April 17, 2006, Revised December 2, 2006, December 3, 2008

"I lost my job and have been making my mortgage payment from savings. At some point, I will run out of savings. What should I do?"

Some variant of this letter is appearing in my mailbox with increasing frequency. The problem is probably going to get worse before it gets better.

Many homeowners faced with this situation do nothing, allowing the problem to overwhelm them when it hits. That is not smart. When you know a tidal wave is coming, you should minimize the damage by preparing for it the best way you can.

In this article, I consider how borrowers who anticipate that they soon will be unable to make their mortgage payments can make the best of a bad situation. The best approach depends importantly on whether or not you have significant equity in your home.

Mortgage Payment Problems When You Have Significant Home Equity

Don’t Practice Denial: If you stick your head in the sand and allow yourself to miss payments, you lose one potentially valuable option: the ability to stay current by raising cash against your equity. So long as your credit is good, you can take out a second mortgage or do a cash-out refinance on your first mortgage. Once you miss payments on the first mortgage, however, you lose this option. No one wants to make a second mortgage to someone who can’t make the payment on the first.

Don’t Expect Help From the Lender: If your ability to pay is impaired but you have substantial equity in your house, informing the lender of your problem is risky. Some lenders will respond positively to help you find a solution, but too many others won’t. A common response is “come back and see us when you have missed two payments.”

The brutal fact is that if you have substantial equity in your house when your income drops, you and the lender are in a conflict situation. (Equity is the current market value of your home, less the balance of all existing liens against it.) Your equity protects the lender against loss. If the lender forecloses, your equity covers not only the loan balance, but also the foreclosure expenses and unpaid interest. The last thing the lender wants, when your ability to pay has been impaired, is to have this equity depleted by your taking out new loans.

Telling borrowers to return after missing two payments removes the danger (to them) of equity depletion. When borrowers return after missing two payments, their credit is shot and they can’t borrow anywhere else.

Using a HELOC to Make the Payment: Borrowers who are current on their mortgage can stay current by borrowing against their equity. The best instrument for this is a HELOC, a credit line, which you can draw on as needed. This doesn’t solve your problem, but it buys time while you find a solution. Within the limited time you have available, your financial situation must recover to the point where you are able to service both loans.

You can estimate how much time you have by dividing 90% of the line by your monthly payment. If your line is $20,000 and your payment $500, for example, you have about 36 months.

Selling the House: If you aren’t confident that your income will be restored during the period a HELOC can keep you afloat, sell the house. At least then you realize the equity in cash. You may still want to use a HELOC to keep the first mortgage current while you sell the house. Obtaining full value sometimes takes some time and you don’t want to be forced into a fire sale.

Forbearance Agreement: If your financial stringency is temporary but you have lost the ability to borrow by falling behind in your payments, there is one other possible option that will keep you in the house: a forbearance agreement with the lender. Under such an agreement, the lender suspends and/or reduces payments for a period, usually less than 6 months, although it can go longer.

At the end of the reduced-payment period, a repayment plan kicks in. You agree to make the regular payment plus an additional agreed-upon amount that will cover all the payments that were not made during the forbearance period. The repayment period is usually no longer than a year.

If the plan is successful, you will be brought current and the lender will suffer no loss. However, the lender will only consider this approach if convinced that your problem is temporary. The burden of proof is on you to document the case.

A forbearance agreement is a second best solution because you won’t get one until you are delinquent. The lender will dictate the terms because you have no place to go.

Your Payment Problem Is Caused or Aggravated By Non-Mortgage Debt

Borrowers with significant equity in their homes, whose payment problems are caused or aggravated by a heavy burden of non-mortgage debt, may be able to extricate themselves by consolidating their non-mortgage debt into a new mortgage. An alternative is consolidation under a Chapter 13 bankruptcy.

The advantage of being your own consolidator is that you stay in charge of your finances, and your credit rating is not materially affected. The disadvantage is that you lose the partial debt burden relief that a Chapter 13 bankruptcy provides.

Being Your Own Consolidator: When you have equity, you can pay off other debts with cash obtained through a cash-out refinance or a second mortgage. Do it if the prospects for success are good.

Consolidation does not reduce your debt, rather it replaces other types of debt with additional mortgage debt. Consolidation will reduce your required monthly payments, however, because mortgage rates are usually lower than non-mortgage rates, the interest is tax exempt, and the term is probably longer. The critical question is whether or not your debts will be manageable after you consolidate. I have three debt consolidation calculators on my web site that should help you answer that question.

You must go this route before you fall behind on your payments. If you fall behind, your credit rating will deteriorate and the terms at which you can consolidate will become increasing onerous. Very quickly the option of being your own consolidator will disappear.

Consolidation Under Chapter 13: Under Chapter 13, you are subject to a debt reorganization and payment plan approved by a court. The plan eliminates interest payments and schedules affordable principal payments to eliminate all non-mortgage debts within a 3 to 5-year period. During this period, you make one monthly payment to a court-assigned trustee, who makes the payments to your various creditors. The creditors are required to accept the plan. When the payment plan has been successfully completed, you are discharged from bankruptcy, but the stain will remain on your credit report for 7 years.

If you do go into Chapter 13, any arrears in your mortgage payments will be added to the other debts that are consolidated. This is so even if you are in foreclosure, provided your house has not been sold. Entering Chapter 13 will stop the foreclosure process. Your mortgage balance stays outside of the Chapter 13 process, however, and you continue to be responsible for the regular scheduled mortgage payments.

Refinancing Out of Chapter 13. If you are in Chapter 13 and have substantial equity in your house, the possibility exists of using it to buy yourself out of Chapter 13.

Some lenders consider people in Chapter 13 with equity in their homes excellent loan prospects. While they wouldn’t touch a debtor who was unable to cope before declaring bankruptcy, the same person can become a good prospect by demonstrating a capacity to handle a reduced burden under Chapter 13. Usually, a lender will look for a perfect Chapter 13 payment record of at least a year.

Ordinarily you would not want to accept such an offer if it meant that your required payments under Chapter 13 would rise as a result. This could happen if your mortgage payments were lower after the refinance and if you have not completed your third year in Chapter 13. Speak to your Chapter 13 trustee before considering a refinance.

Assuming a refinance would not affect your Chapter 13 payments, it may or may not pay to wait, depending on the urgency of your need. Lenders who will limit their loans to 70 or 75% of property value when you are in Chapter 13, may go to 90% or 95% after you are out. Bear in mind, though, that your loan will be classified sub-prime in either case and it will be pricey. To graduate to a higher-quality status and better price, wait another 2 years after exiting Chapter 13.

If You Don't Have Significant Home Equity

Borrowers with no equity can’t open a credit line and draw on it to stay current on their mortgage, nor can they consolidate non-mortgage debts in a new mortgage. The options they have all require the concurrence of the lender.

But that does not mean that they have no leverage. The lack of equity makes foreclosure an unattractive option to the lender. With no equity, the lender who forecloses is not reimbursed for lost interest, foreclosure expenses or real estate sale commissions. Further, the process takes time, during which the borrower lives rent-free. Even if the borrower has other assets, in most states they are beyond the reach of lenders who have foreclosed a mortgage that arose in a home purchase transaction. Hence, lenders are usually receptive to alternatives to foreclosure that cost less.

The most attractive of these to the lender is a forbearance agreement, where payments are suspended for a period, to be made up by larger payments scheduled for the future. If forbearance works, it costs the lender nothing. On the other hand, if it doesn’t work, delaying the foreclosure will raise the cost. For this reason, a lender will only consider forbearance if convinced that the borrower’s problem is temporary.

A temporary reversal is one where, if you are provided payment relief for up to 6 months, you will be able to resume regular payments at the end of the period, and repay all the payments you missed within the following 12 months. If you believe that that is the case, prepare to document it.

If your problem is not temporary, the lender may still be receptive to alternatives that are less costly than foreclosure. The most attractive of these to a borrower, because it allows the borrower to remain in the house, is a loan modification that reduces the payment. This could be a lower interest rate, longer term, a different loan type, or any combination of these. Unpaid interest may be added to the loan balance.

Loan modification might be acceptable to a lender if the borrower’s income has been reduced to the point where the current payment is not affordable but a smaller payment is. A lender is likely to be most receptive to a loan modification if convinced that the borrower’s inability to pay is completely involuntary, and that modification would be less costly than foreclosure. For a more extended treatment of this topic, see Mortgage Loan Modifications.

Borrowers with no prospects of a turn-around in their fortunes, who are unable to pay even with a loan modification, must resign themselves to giving up their houses. Even then, lenders will consider alternatives to foreclosure, especially if they are convinced that borrowers are operating in good faith. If the borrower can find a qualified purchaser who will take title in exchange for assuming the mortgage, the lender is likely to allow it. This is called a workout assumption.

Alternatively, the lender may be willing to accept either a short sale or a deed in lieu of foreclosure. In the first, the borrower sells the house and pays the sales proceeds to the lender. In the second, the lender takes title to the house. In both cases the debt obligation usually is fully discharged. Both a short sale and a deed-in-lieu appear on the borrower’s credit report, and as far as I can determine, they reduce the borrower's credit score as much as a foreclosure.

In some jurisdictions, foreclosure is so costly for the lender relative to short sale or deed-in-lieu that borrowers have bargaining leverage. I have heard of cases in which the borrower got the lender to agree not to report the transaction to the credit bureau if they did a deed-in-lieu.

Most lenders, however, are averse to making such deals with borrowers who have the capacity to continue making payments but would like to stop because they have negative equity – their loan balance is larger than their house value. Borrowers who try to rid themselves of negative equity through short sale or deed-in-lieu may get a chilly reception.