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Mortgage Debt: Foreclosure – What is it and How Do I Avoid It?

Foreclosure Sign

image by JefferyTurner

What is a Foreclosure?

A foreclosure is a legal process a mortgage lender can pursue in the event of non-payment to force the sale of a property (usually a home).  Each state and even specific localities have drastically different laws and approaches to the foreclosure process, but there are generally two types of foreclosures: Judicial and Non-Judicial.  In a judicial foreclosure, the lender must file a lawsuit against the borrower to begin foreclosure and the entire process is overseen by the court.  In a non-judicial foreclosure, the original agreement between borrower and lender dictates that the lender has the right to sell the property under certain conditions without court supervision.  Generally in the non-judicial states, this agreement is captured under a power of sale or deed of trust.  While there used to be a general rule of thumb that foreclosure was imminent if you fell three months behind on payments, this rule has fallen away with the recent rash of delinquencies and the financial meltdown of 2008.  Nonetheless, if you are behind on some payments and feel you may be facing foreclosure, knowing the basic process will be invaluable.  It is well worth a couple hours of your time to use a search engine and some of these key terms I’ve outlined to get a basic understanding of what may be to come.  This will also give you the opportunity to ask more informed questions and make better decisions when/if the process occurs.

Foreclosure Alternatives

There are numerous alternatives available if you fall behind on your mortgage payments.  You should never assume foreclosure will occur simply because you’re past due.  Depending on too many factors to discuss in this brief article, there could be options such as a loan refinance, negotiating a deed in lieu of foreclosure, selling your home (either through a traditional sale or a “short” sale, a concept we’ll discuss in a future article), etc.  The main factor in determining which of these alternatives make sense is to first determine the root cause of becoming past due.  If you truly cannot afford the home you live in, it is time to get serious about making a change.  If you have experienced a short-term hardship, it may be as simple as calling the mortgage company and requesting a hardship (usually called “forbearance”) program.

In reply to the housing and foreclosures issues in the past few years, the federal government established the Making Home Affordable (MHA) program.  MHA provides options for those facing foreclosure to avoid it through numerous programs and loan modification options.  The program’s website is set up to point you to solutions based on your situation.  If you’re facing foreclosure, I’d highly recommend you visit that website to learn more about what options are available to you.  Keep in mind, though, that if you are in a home you can’t truly afford, don’t try to stay if the math says you can’t.

Tax Implications of a Foreclosure

The Mortgage Forgiveness Debt Relief Act of 2007 provides that in the event of foreclosure on your primary residence, you generally will not have to pay taxes on the debt forgiveness.  However, this provision is only active (as of now) through 2012.  Normally, debt forgiven by a lender is considered taxable income to the borrower and the borrower should expect to be required to pay taxes on it.  The takeaway here: if you’re facing foreclosure, don’t be so sure you won’t have to pay some money in taxes once the foreclosure is completed.

Foreclosures and My Credit Rating

As you might expect, a foreclosure will have a negative impact on your credit score.  According to summary data released by Fair Isaac (the agency behind the FICO Score), you should expect your credit score to go down by 85-160 points in the event of a foreclosure. This is not as bad as a bankruptcy, but will still be a huge black mark on your record that you won’t begin to recover from for at least a few years.

Avoiding Foreclosure

Time for me to sound like a broken record: if you are struggling to pay all your bills, you need to find out if you have a math problem or a behavior problem.  If the math of your income vs. your expenses works, then you really need to buckle down and fix the behavior.  That means living on and sticking with your budget!  If the math is messed up and you truly can’t afford your lifestyle, something has to change.  Be it your income or the expenses, you can’t do any magic when the math is broken.  Sell stuff and cut expenses or bring in some extra cash.  Trust me – you do NOT want to go through a foreclosure.  Don’t put yourself in a position of risk that makes it a possibility.  As Dave Ramsey says, live like no one else so that later, you can live like no one else!

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