The struggling housing market has led to a wave of foreclosures over the last year or so. The collapse of the subprime market coupled with rising unemployment found many homeowners in properties they could no longer afford. For some, foreclosure actually seems like a relief under the stress of high monthly mortgage payments. But what many do not realize is that the foreclosure process does not necessarily wipe out your debt and it may not be so easy to just walk away.
To understand the true impact of foreclosure, you must understand the mechanics of the process. When a bank forecloses on a loan, it assumes the property and sells it at auction. If it is able to recover its loss through that process, the homeowner will not owe anything additional. If, however, it cannot collect the full outstanding loan amount by selling the property, you may still owe the difference.
An additional problem occurs when there is a second mortgage, or home equity loan, on the property. In a foreclosure a second mortgage is second in line for any money recovered. This is called subordination. That means if the property is sold for a loss, the second mortgage lender only recovers whatever is left after the first lender is made whole. In most cases, the second mortgage lender gets little to nothing after a foreclosure.
As a result, homeowners who have a home equity loan on their property and go through a foreclosure on their first mortgage may find themselves with a home equity loan that has been converted into what amounts to an unsecured personal loan. The home equity lender may decide not to write off the balance on the loan and continue to bill the borrower even after the home has been sold. Borrowers are still liable for this debt because they signed a promissory note to repay it.
If the mortgage was refinanced or the home equity loan was taken out after the original purchase, the lender may be able to sue the borrower for the balance plus interest and legal fees. This could result in wages being garnished. In some states, if a home equity loan was used towards the purchase price of the property (i.e. with an 80/20 loan configuration), the home equity lender cannot file a lawsuit to get a judgment against the borrower for the remainder of the balance on the loan. This is not true in all states. Lenders do not often take borrowers to court under these circumstances, but it is possible.
Regardless of whether a borrower is sued, the outstanding balance may still appear on the borrower’s credit as a charge-off until the loan is repaid or settled. This can severely damage your credit for the duration. Of course, your credit score has probably already plummeted as a result of the foreclosure.
Every case is different because some lenders will be more willing to write off losses than others. Working with your lender to avoid foreclosure is always the best option to preserve your credit.
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