Because mortgage indebtedness is secured by a lien on the mortgaged property, the lender (mortgagee) has the right to foreclose on a defaulted mortgage note and repossess the property. Doing so could allow the lender to recover (in whole or in part) the debt incurred by the borrower (mortgagor) through resale of the property.
While a mortgage could be considered in default when only one monthly payment is in arrears, it is unlikely that the lender will begin foreclosure proceedings at that point. Generally, the loan servicer will communicate with the borrower about the arrearage and ways to address it, and a lender will not be likely to initiate foreclosure proceedings until it’s reasonably certain the borrower is truly defaulting on the loan.
Depending on the state where it occurs, a foreclosure proceeding may be accomplished in as little as three to six months, or it may take a year or more. The difference depends on whether the state requires a judicial foreclosure (through a court hearing) or allows non-judicial foreclosures; judicial foreclosures take longer. Generally, once the borrower falls three months past due on the mortgage, the service will send a notice of default. If the total default is not cured within a reasonable period of time (30-120 days), the mortgage is turned over to the lender’s loss mitigation department, a notice of sale is filed and advertised in the local newspaper (in judicial foreclosure states, this happens after a hearing is held to determine that the borrower is in default), and an auction date for sale of the home is scheduled. At the sale, the foreclosing lender establishes an opening bid, which is usually equal to the outstanding mortgage balance plus any accrued interest and collection costs/attorney fees. The property is sold to the highest bidder. If there are no bids higher than the opening bid, the property is retained by the lender as Real Estate Owned.
Depending on state law, the borrower may be granted a redemption period that may begin either before the auction sale or immediately thereafter (if the property has not been purchased by a third party at the auction). During this period, the borrower has the opportunity to retain the property by repaying the lender the full amount due on the mortgage (including any accrued interest and collection costs). Once the redemption period ends, if the property has not been redeemed by the borrower, the borrower is required to vacate the property. If the borrower does not do so, the lender may have the borrower evicted. While in some circumstances the lender may be willing to rent the property to the borrower, this is not likely.
After a foreclosure is completed, a borrower may have to wait up to seven years before becoming eligible to apply for a new mortgage. A foreclosure may be averted at any time during the process, up to and including the auction sale date. It is of course easier to work out an alternative to foreclosure earlier in the process than it is later in the process. Here are some alternatives.
A borrower that has fallen in arrears on mortgage payments due to a temporary financial setback may be able to address the arrearage through a workout plan set up by the lender through the mortgage service. In most cases, these plans allow the borrower to catch up on the arrearage over a short period of time.
A lender may offer a borrower a forbearance, which allows a temporary reduction or suspension of the mortgage payments while the borrower regains firmer financial footing. A forbearance is most often combined with a reinstatement or repayment plan. In a reinstatement, the borrower agrees to cure the arrearage with a lump-sum payment by a specific date (for example, once a tax refund or year-end bonus arrives). In a repayment plan, the borrower agrees to cure the arrearage over a specified period. For example, a borrower two months behind might bring the mortgage current by making a regular mortgage payment and a half payment over a four-month period.
If a borrower shows the financial ability to continue making mortgage payments, but does not have the wherewithal to catch up on an arrearage with a workout plan, the lender may offer the borrower a mortgage loan modification. A loan modification is a written agreement between the borrower and the lender that permanently changes one or more terms of the mortgage note in an effort to make the monthly payments more affordable. A mortgage modification may include one or more of the following:
In this modification, often called recasting the mortgage, the unpaid mortgage balance (including the arrearage) is reamortized over a new term. This can be particularly helpful to borrowers who are at least a few years into repayment over the original term. For example, a mortgagor who borrowed $250,000 at 5 percent for a 30-year term will have a monthly payment (principal and interest) of $1,342. After six years, the remaining unpaid principal is $224,838. If that amount is reamortized at the same rate over a new 30-year term, the monthly mortgage payment will be reduced to $1,207.
The further a borrower is into the original term, the more a reamortization helps lower the monthly payment. The new term does not have to be the same as the original term; it could be extended, or even made shorter if the default occurs near the end of the original term. Unlike a mortgage refinancing, there are no closing costs involved in a reamortization, and it brings the mortgage current.
Reducing the interest rate
A lender may agree to reduce the interest rate charged on the remaining balance of the mortgage. This may be done on a temporary basis, with the interest rate increasing, either gradually over a period of time or all at once, or it may be done on a permanent basis over the remaining term of the loan. Reducing the interest rate on the remaining mortgage balance is often coupled with reamortizing the balance over a new term.
Deferring or reducing principal
In an effort to make the monthly mortgage payment affordable, a lender may defer a portion of the principal, computing the new monthly payment on the reduced principal balance. Any deferred principal would generally become due upon sale of the property, refinancing of the mortgage, or at the end of the modified loan’s term. While there is usually no interest accruing on deferred principal, the borrower should read the new agreement carefully to verify that such is the case.
In some instances, the principal may be reduced. If the value of the property has dropped substantially below the unpaid mortgage balance due, and the lender determines it may in the final analysis recoup more from repayment of a principal-reduced loan than from a foreclosure and subsequent resale of the property, the lender may decide to reduce the principal, thus salvaging the most possible from the situation.
Caution: Reducing principal may have tax consequences, since the IRS typically treats such forgiven debt as taxable income.
In some cases, the borrower may not have the wherewithal either to cure an arrearage through a workout plan or a mortgage modification, or to manage monthly repayment of the mortgage on an ongoing basis, no matter how liberal the modification. In such cases, the borrower might choose to avoid foreclosure by pursuing a short sale or a deed-in-lieu of foreclosure.
A short sale occurs when a mortgage lender allows a borrower (the short seller) to accept a sale offer that is less than (“short”) the balance due on the outstanding loan. Lenders generally will consider this option only when (a) the market value of the home is less than the mortgage balance due, and (b) the borrower, having fallen behind on mortgage payments, has little hope of bringing the mortgage current even if it were modified. The lender expects the proceeds from the short sale will be greater than what could be expected in a foreclosure.
If the proceeds from the sale don’t satisfy the total mortgage and/or lien balances due on the property, one or more deficiencies may occur. Short sellers should always find out (in writing) what will happen to any deficiencies. If a deficiency isn’t forgiven, the lender may be able (depending on state law and how the mortgage note or lien is structured) to pursue the borrower for it.
Junior liens (e.g., second mortgages, home equity loans, or other liens) are not dissolved in short sales (as they are in foreclosures). As a result, either the short seller or the first lienholder may have to give some consideration (something as low as pennies on the dollar) to junior lienholders to satisfy their claims. The short seller should again get notification in writing of what will happen to any remaining deficiencies that might result from settling junior lienholder claims.
Caution: Keep in mind that forgiven deficiencies can also have tax consequences, however exclusions may be available through the Mortgage Debt Relief Act.
Tip: After completing a successful short sale, borrowers may be eligible to apply for a new mortgage on another home after two years.
Deed-in-lieu of foreclosure
In a deed-in-lieu of foreclosure (often referred to as a DIL), a mortgage lender allows a borrower to sign the deed over to the lender in exchange for relief from the obligation to repay the mortgage. DILs are usually issued only if the value of the property is less than the indebtedness against it and the borrower no longer has the ability to pay the mortgage. Prior to accepting a DIL, a lender usually must be convinced that the property cannot be sold (even by short sale) within a reasonable amount of time.
Lenders will generally accept a DIL only if the property has no other liens against it. As a result, property tax liens may need to be paid in full, and other junior lienholders may need to be offered some compensation to satisfy their claims and discharge their liens. Considering that a foreclosure sale would discharge junior liens without any compensation to the lienholders, many junior lienholders might be happy to “take what they can get.”
In most cases, a DIL agreement forgives a borrower of any obligation to repay a deficiency if all the conditions of the agreement have been met. Forgiven deficiencies can have tax consequences. However, an exclusion may be available through the Mortage Debt Relief Act.
Homeowners who successfully complete a DIL are typically eligible to apply for a new mortgage four years after the execution of the DIL (this time period may be less if there are extenuating circumstances).
Chapter 13 bankruptcy
An individual unable to obtain an affordable mortgage modification, but possessing the financial wherewithal to bring the mortgage current over an extended period of time (three to five years), might consider filing a Chapter 13 bankruptcy petition. Any individual can file under Chapter 13 as long as the debtor’s unsecured debts (such as credit card debt) are less than $465,275 and secured debts (such as mortgages and car loans) are less than $1,395,875 (figures are effective as of April 1, 2022, and are indexed annually for inflation every three years).
Filing a Chapter 13 bankruptcy petition creates an automatic stay; creditors (including mortgagees) are prohibited from pursuing further debt collection activity (including foreclosure). The petitioner then files a reorganization plan, spelling out how his or her debts will be repaid over a three- to five-year period. If the debtor’s average monthly income (over the previous six months) multiplied by 12 is less than the applicable state’s median income, the repayment period is three years; if it’s greater, the repayment period must be five years.
Insofar as the mortgage is concerned, the petitioner must make timely current mortgage payments during the repayment period, plus repay the arrearage in monthly “installments.”
Example(s): John has a mortgage of $300,000 on his principal residence. His monthly payments (principal and interest) are $1,600. At the time he files the Chapter 13 petition, he is seven months behind on his mortgage. With collection costs and attorney fees, he owes the mortgagee a $12,000 arrearage. He is eligible for a five-year Chapter 13 repayment period. During that time, he must make a normal $1,600 monthly mortgage payment to his mortgagee, plus a monthly payment of $200 ($12,000 divided by 60) through the courts to address the arrearage.
Current bankruptcy law does not allow the courts to “cram down” debt secured by a principal residence. The mortgage balance due may be greater than the value of the property that secures it, but the courts can do nothing about that. Nor can the court lower the interest rate on the mortgage, recast the arrearage, or reamortize the entire debt. All the court can do is stop the foreclosure proceedings and allow the debtor time to address the arrearage through the repayment plan. If the debtor completes the court repayment plan successfully, the mortgage will be brought current.