The debt settlement strategy has generally been limited to negotiating unsecured debt accounts like credit card debt, store charge cards, personal loans, and medical bills. With secured debts, there is always collateral at stake, in the form of property like a home or vehicle. Given the right of secured creditors to foreclose or repossess property, it didn’t make much sense to apply the same tactics to secured debts. So whenever a debt settlement client would ask for my advice about their mortgage, my usual response was, “Don’t mess with secured debts.”
How times have changed! Today, after a multi-year flood of foreclosures, we’re in an era where first loan modifications and second lien settlements have become quite common. This article will specifically focus on the settlement of second mortgages, or home equity lines of credit (HELOCs), where a”settlement” is defined as an agreement by the creditor to accept less than the principal balance on the note. In what follows, I’m assuming the loan in question is a recourse” loan, meaning the lender would have the right to pursue legal action even if the first lender had foreclosed upon the property. Generally speaking, most second mortgages or HELOCs are in this category. However, as I discussed in this recent blog post, some of my clients have reported extraordinary settlements of 10-15% on their seconds.
First, let’s address the most common question people have: How is it possible to settle a second mortgage? Every real estate situation carries its own unique set of numbers, but if conditions are right, settlement is possible. Lets’s talk about those conditions. It all starts with whether or not there is equity remaining in the property after the first mortgage is satisfied. For example, if you owe $400,000 on a first mortgage and your house is showing on Zillow.com for $350,000, then you are “upside-down” on the first mortgage alone. However, if there is a second lien on top of the first in the form of a mortgage or an equity line of credit, that note is 100% underwater. In such cases, it may be possible to negotiate a significant settlement with the second mortgage holder.
Settlement of second liens breaks down into two main categories – before foreclosure or after foreclosure. Settlement of second mortgages before a foreclosure action initiated by the first mortgage lender is possible in many cases where the second lien is totally exposed (or even just partly exposed). For example, a short sale often leads to this type of negotiation. But there have also been cases where the debtor stayed in the property, obtained a loan modification from the first lender (thus avoiding foreclosure), and successfully settled with the second mortgage holder.
Why is this possible at all? Why are lenders accepting such low settlements on second mortgages on these types of accounts? In my view, it’s primarily the bankruptcy factor coming into play here. Many people will rightfully balk at the idea of filing bankruptcy when the debt load in question is, say, only $30,000. But the second mortgage of $80k, $100k, even $250k or more is a different story, and such high balances make bankruptcy a compelling option for consumers. The critical factor is that second liens can be stripped in Chapter 13 bankruptcy (i.e., converted to unsecured debts and included in the bankruptcy plan). Lenders know this, so they walk a much narrower tightrope than credit card banks do in terms of collection practices, just based on the enormous dollars involved. Push too hard, no recovery.
What about the settlement of second mortgages AFTER foreclosure? Once a home is lost to foreclosure, there is often little or nothing left after the auction sale to cover the second lien, leaving the second lender holding the bag. Adding insult to injury, many former homeowners are shocked to learn that foreclosure does not end the potential financial problems associated with the lost property. As noted above, second mortgages are usually recourse loans, meaning they are a type of contract that permits the lender to pursue recovery against the unpaid balance even *after* the original collateral has been lost to foreclosure. It is common for consumers to receive aggressive notices and threatening phone calls from a lender attempting to recover against a second lien. How should such a situation be handled? Should you negotiate a settlement or simply ignore the threats?
Assuming the consumer has not declared bankruptcy yet, the valid question here is, “What is my risk?” The correct answer is” “Nobody knows the risk for sure.” This is new territory. We simply have never had a situation where $1 trillion of second mortgages are sitting on the books at valuations far more than what they are worth on the market. So far, lenders have been reluctant to litigate these claims, and no clear pattern of legal collections has taken place relative to second liens, pre or post-foreclosure.
Based on this perspective, one school of thought among debt advisors says, “Don’t even bother settling a sold-off junior lien, since even recourse lenders are not pursuing litigation on these charged-off loans. Instead, wait out the Statute of Limitations (SOL) for your state, and then you are in the clear.
Folks, I think that’s terrible financial advice. For one thing, the SOL period varies from state to state, all the way from 3 years in states like North Carolina to 15 years for Ohio, with most states having an SOL period of 4-6 years. So for the average person, three years or more is an unacceptably long time to wait with crossed fingers hoping that nothing terrible will happen meanwhile.
Further, your credit standing will be compromised as long as the second lien remains unresolved. It will sit there on your credit report, and even if (after time) it no longer affects your FICO score, virtually all prospective lenders will treat it as an open obligation. Therefore it *will* be counted in your current debt-to-income ratio—Goodbye new mortgage, refinancing, auto loan, etc.
Perhaps more importantly, as they say in the investment industry, past performance does not guarantee future results. Just because JP Morgan Chase, Citibank, Bank of America, and other major lenders have not been aggressively litigating these second mortgage claims yet, that does not mean you won’t see a full-court press in 2012 or beyond. There are BIG dollars at stake, with the four largest lenders holding some $400 billion in overvalued second mortgages or roughly 40% of the total.
Also, with that much money at stake, it’s only a matter of time before the significant debt purchasers gear up to work these types of accounts. We can expect a take-no-prisoners approach from the worst of them and unrealistic settlement requirements from many others. For a consumer who can raise the resources needed to settle an unresolved second lien for 10-15%, it makes all the sense in the world to put the fire out before it gets going.
Let me inject some critical caveats. First, I am NOT suggesting that consumers start purposely defaulting on their second mortgages simply because they are out to save some money or get better loan contracts. Settlement of second liens is a strategy that applies in many distressed property situations, but it is certainly not applicable in all cases. Also, very importantly, not all second mortgages and HELOCs are created equal. Some creditors are much more stubborn about a settlement, depending on the type of loan, whether it was packaged for sale to investors, and so on.
In closing, the best general advice I can offer is to step back from the emotions associated with any property you own. Instead, look at the raw numbers and let the math do the talking. Check the current value of your property and assess where you stand in terms of the second mortgage. If your analysis indicates the second mortgage or HELOC is uncovered by 100% or more, then other factors aside, this fact alone points toward further consideration of the settlement strategy. Consult with a professional financial advisor knowledgeable in this area, but be wary of anyone promising a quick fix for mortgage problems. Settlement of any significant contractual obligation like a mortgage or note requires patience, commitment, and determination.