One of the most important risks in making a mortgage loan is that the borrower will default on the note in some way, so that the lender may not receive the expected mortgage payments. The risk associated with mortgage loans depends in part on the rights of the lender if and when such default occurs. Thus, it is important to understand the legal ramifications of mortgage default.
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What Constitutes Mortgage Default?
Default is a failure to fulfill a contract, agreement, or duty, especially a financial obligation such as a note. It follows that a mortgage default can also result from any breach of the mortgage contract. The most common default is the failure to meet an installment payment of the interest and principal on the note. However, failure to pay taxes or insurance premiums when due may also result in a default, which may precipitate an acceleration of the debt and a foreclosure action. Indeed, some mortgages have clauses that make specific stipulations to this effect. Even a failure to keep the security in repair may constitute what is commonly referred to as a technical default. However, because a breach of contract resulting in a technical default can usually be cured by a borrower, it seldom results in an actual foreclosure sale. Furthermore, it may be difficult for the mortgagee to prove that the repair clause in the mortgage has been broken unless the property shows definite evidence of the effects of waste. This means that even though there is a breach of contract, the mortgagee may postpone doing something about it. However, in the case of technical default accompanied by abandonment, the probabilities are that the mortgagee will act quickly to protect his or her interests against vandalism, neglect, and waste. This may occur even though the borrower may be current on the loan payments.
Alternatives to Foreclosure: Workouts
Foreclosure involves the sale of property by the courts to satisfy the unpaid debt. The details of this process are discussed later. Because of the time involved and the various costs associated with foreclosure (and possibly repair of any damage to the property), lenders often prefer to seek an alternative to actual foreclosure. Although mortgage contracts normally indicate definite penalties to follow any breach therein, experience has shown that in spite of provisions for prompt action in case of a default in mortgage payments, many commitments are not met in strict accordance with the letter of the contract. Instead, whenever mortgagors get into financial trouble and are unable to meet their obligations, adjustments of the payments or other terms are likely to follow if both the borrower and lender believe that the conditions are temporary and will be remedied. The term workout is often used to describe the various activities undertaken to deal with a mortgagor who is in financial trouble. Many times the parties make a workout agreement that sets forth the rules by which, during a specified period of time, they will conduct themselves and their discussions. The lender agrees to refrain from exercising legal remedies. In exchange the borrower acknowledges his or her financial difficulty and agrees to certain conditions such as supplying current detailed financial and other information to the lender and establishing a cash account in which any rental receipts from the property are deposited and any withdrawls are subject to lender approval.
Six alternatives can be considered in a workout:
1. Restructuring the mortgage loan.
2. Transfer of the mortgage to a new owner.
3. Voluntary conveyancy of the title to the mortgagee (lender).
4. A “friendly foreclosure.”
5. A prepackaged bankruptcy.
6. A “short sale” with the lender agreeing to a sale price less than the loan balance.
Restructuring the Mortgage Loan
Loans can be restructured in many ways. Such restructuring could involve lower interest rates, accruals of interest, or extended maturity dates. If the original loan is non-recourse to the borrower, the lender may want to obtain personal recourse against the borrower as part of the loan restructuring agreement. This makes the borrower subject to significantly more downside risk if the restructuring fails. The lender also may want a participation in the performance of the property to enhance the lender’s upside potential as compensation for being willing to restructure the loan. For example, the lender could ask for a percentage of any increase in the income of the property over its current level.
Recasting of Mortgages
Once a mortgage is executed and placed on record, its form may change substantially before it is redeemed. It may be recast for any one of several reasons. A mortgage can be renegotiated at any time, but most frequently it is recast by changing the terms of the mortgage (either temporarily or permanently) to avoid or cure a default. Where mortgage terms such as the interest rate, amortization period, or payment amounts are changed, mortgagees must exercise care to avoid losing their priority over intervening lienors. The mere extension of time of payment will not generally impair the priority of the extended mortgage. Courts, however, are watchful to protect intervening lienors against prejudice, and mortgages may lose priority to the extent that changes in the interest rate, payment amounts, or the amount of indebtedness place additional burdens on the mortgagor.
Recasting of mortgages to admit interests not present at the time the mortgages were executed is sometimes necessary. For example, the mortgage may make no provision for an easement of a public utility company that requires access to the rear of the site covered by the mortgage. Since the installation of the services of the utility will normally add to rather than subtract from the value of the security, the mortgagee will usually be glad to approve the change. Nevertheless, it will require a recasting of the mortgage to the extent indicated.
Extension Agreements
Occasionally, a mortgagor in financial difficulty may seek permission from the mortgagee to extend the mortgage terms for a period of time. This is known as a mortgage extension agreement. A mortgagor may request a longer amortization period for the remaining principal balance or a temporary grace period for the payment of principal or interest payments or both. In responding to such a request, the mortgagee needs to consider the following issues:
- What is the condition of the security? Has it been reasonably well maintained or does it show the effects of waste and neglect?
- Have there been any intervening liens? These are liens recorded or attached after the recordation of the mortgage but before any modifications to it. If so, what is their effect upon an extension agreement? If such liens exist, it is possible that the extension of an existing mortgage may amount to a cancellation of the mortgage and the making of a new one. If so, this could advance the priority of intervening liens.
- What is the surety status of any grantees who have assumed the mortgage? Will an extension of time for the payment of the debt secured by the mortgage terminate the liability of such sureties? The best way for mortgagees to protect themselves against the possibilities implied in these questions is to secure the consent of the extension agreement from all sureties to the extension. As parties to it, they can have no grounds for opposing it. But if they are not made parties to the extension—particularly if changes in the terms of the mortgage through the extension agreement tend to increase the obligations for which the sureties are liable—then care should be exercised to ensure that those sureties who refuse to sign the agreement are not released by the extension agreement. The possibility of foreclosure and a deficiency judgment against them may be a sufficient inducement to obtain their agreement to be parties to the extension.
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The exact nature of an extension agreement depends upon the bargaining position of mortgagor and mortgagee. If mortgagors can refinance the loan on more favorable terms, they will probably not apply for an extension agreement. Alternatively, they may have to
make changes that favor the mortgagee, such as an increase in the interest rate.
Alternative to Extension Agreements
An alternative to an extension agreement has the mortgagee agree informally to a temporary extension without making any changes in the formal recorded agreement between the parties. If the mortgagor is unable to meet all monthly mortgage payments, these too may be waived temporarily or forgiven in whole or in part. For example, simply raising the question of such an agreement suggests that the mortgagor cannot pay the matured principal of the loan. Therefore, some informal arrangement may be made to permit the mortgagor to retain possession of the property in return for meeting monthly payments, which may or may not include principal installments. The use of this kind of informal agreement can be troublesome, but, in general, if it is reached, the amounts demanded will be adjusted to the present payment capacities of the borrower. Should the borrower’s financial condition improve, the lender may again insist that the originally scheduled payments resume.
The use of such an alternative to a definite extension agreement may serve the temporary needs of both mortgagors and mortgagees. If the latter feel that the security amply protects their lien, the mortgagees can afford to be lenient in helping mortgagors adjust their financial arrangements during a difficult period. If the mortgagors also feel that any real equity exists in the property, they will wish to protect it if at all possible.
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Transfer of Mortgage to a New Owner
Mortgagors who are unable or unwilling to meet their mortgage obligations may be able to find someone who is willing to purchase the property and either assume the mortgage liability or take the property “subject to” the existing mortgage. The new purchaser may be willing to accept the transfer of mortgage if he or she thinks the value of the property exceeds the balance due on the mortgage. In either case, the seller retains personal liability for the debt. However, if the seller is about to default and expects to lose the property anyway, he or she may be willing to take a chance on a new purchaser fulfilling the mortgage obligation. The risk is that the new buyer will default, and the seller will again have responsibility for the debt and get the property back.
Recall that if purchasers acquire the property “subject to” the existing debt, they do not acquire any personal liability for the debt. Thus, they can only lose any equity personally invested to acquire the property. This equity investment may be quite small where the sellers are financially distressed and face foreclosure. Thus, the buyers may have little to lose by taking a chance on acquiring the property subject to the mortgage. If it turns out to be a good investment, they will continue to make payments on the debt, but if they find that the value of the property is unlikely to exceed the mortgage debt within a reasonable time frame, they can simply stop making payments and let the sellers reacquire the property. Thus, we see that in this situation buyers of the property “subject to” a mortgage have in effect purchased an option. The equity that buyers invest is the payment for this option, which allows them to take a chance on the property value increasing after it is acquired. We can therefore see why purchasers might even give the sellers money to acquire a property subject to a mortgage even if the current value of the property is less than the mortgage balance.
For example, suppose a property has a mortgage balance of $100,000. Property values in the area are currently depressed, and the owner believes that only $99,000 could be obtained on an outright sale. However, a buyer is willing to acquire the property at a price of $101,000 “subject to” the existing mortgage. Thus, $2,000 is paid for the option of tying up the property in hopes that property values rise above their current level.
The seller would receive $1,000 in cash, but since the seller had –$1,000 in equity he or she receives the economic benefit of $2,000, which is also the difference between the price paid and the market value of the property. If the property does not rise in value to more than $100,000 (less any additional principal payments that have been made), the purchaser could simply walk away, and the original owner again becomes responsible for the mortgage. If the property rises in value to more than $101,000, the purchaser stands to make a profit and would continue to make payments on the mortgage. It should be clear that knowledge of various legal alternatives (e.g., being able to purchase a property “subject to” versus assuming a mortgage) can allow a buyer and seller to arrive at an agreement that best meets their financial objectives. Thus, legal alternatives can often be evaluated in a financial context.
Voluntary Conveyance
Borrowers (mortgagors) who can no longer meet the mortgage obligation may attempt to “sell” their equity to the mortgagees. For example, suppose that the mortgagors are unable to meet their obligations and face foreclosure of their equity. To save the time, trouble, and expense associated with foreclosure, the mortgagees may make or accept a proposal to take title from the mortgagors. If they both agree that the property value exceeds the mortgage balance, a sum may be paid to the mortgagors for their equity. If the value is less than the mortgage balance, the lenders may still be willing to accept title and release the mortgagors from the mortgage debt. This voluntary conveyance might be done because the cost of foreclosure exceeds the expected benefit of pursuing that course of action.
When voluntary conveyances are used, title is usually transferred with a warranty or quitclaim deed from mortgagors to mortgagees. The mortgagors should insist upon a release to make sure that they are no longer bound under their note and mortgage, especially in situations where the mortgage balance is near or in excess of the property value. Otherwise, the mortgagors may find that they still have a personal obligation to pay the mortgage note. The conveyance to the mortgagees in exchange for a release from the mortgage debt is frequently referred to as giving deed in lieu of foreclosure of the mortgage. A deed in lieu of foreclosure has the advantage of speed and minimizes the expense of transferring the property and the uncertainty of litigation. It also avoids the negative publicity of foreclosure or bankruptcy. A deed in lieu of foreclosure does not cut off subordinate interests in the property. The lender must make arrangements with all other creditors. There are also potential bankruptcy problems. The transfer may be voidable as a preferential transfer. In addition to the legal questions involved in voluntary conveyances, the mortgagee frequently faces very practical financial issues as well. If there are junior liens outstanding, they are not eliminated by a voluntary conveyance. Indeed, their holders may be in a better position than before if the title to the property passes to a more financially sound owner. Unless in some manner these junior liens are released from the property in question—possibly by agreement with their holders to transfer them to other property owned by the mortgagor or even on occasion to cancel them—the mortgagee may find it necessary to foreclose instead of taking a voluntary conveyance because the title conveyed is subject to junior liens. Foreclosure provides the mortgagee with a lawful method of becoming free from the liens of the junior claimants.
Friendly Foreclosure
Foreclosure can be time-consuming and expensive, and there can be damage to the property during this time period. A “friendly foreclosure” is a foreclosure action in which the borrower submits to the jurisdiction of the court, waives any right to assert defenses and claims and to appeal or collaterally attack any judgment, and otherwise agrees to cooperate with the lender in the litigation. This can shorten the time required to effect a foreclosure. This also cuts off subordinate liens and provides better protection in case of the borrower’s subsequent bankruptcy. A friendly foreclosure normally takes more time than a voluntary conveyance but is less time-consuming than an unfriendly foreclosure. This is discussed in more detail in the next section.
Prepackaged Bankruptcy
The mortgagee must consider the risk that the mortgagor will use the threat of filing for bankruptcy as a way of reducing some of his or her obligation under the original mortgage agreement. Bankruptcy can have significant consequences for secured lenders. To the extent that the collateral securing the debt is worth less than the principal amount of the debt, the deficiency will be treated as an unsecured debt. In a prepackaged bankruptcy, before filing the bankruptcy petition, borrowers agree with all their creditors to the terms on which they will turn their assets over to their creditors in exchange for a discharge of liabilities. This can save a considerable amount of time and expense compared with the case where the terms are not agreed upon in advance. The consequences of bankruptcy are discussed further in the last section of this chapter.
Short Sale
A short sale is a sale of real estate in which the proceeds from the sale fall short of the balance owed on a loan secured by the property sold. In a short sale, the mortgage lender agrees to discount the mortgage loan balance because of an economic or financial hardship on the part of the mortgagor. This is often done during periods when home prices have declined significantly and the financial hardship is more a result of market conditions than actions of the borrower.
In a short sale, the home owner/borrower sells the mortgaged property for less than the outstanding balance of the loan and then turns over the proceeds of the sale to the lender, usually in full satisfaction of the loan. In some cases, the lender may still pursue a deficiency judgment. The lender has the right to approve or disapprove a proposed sale. Typically a short sale is executed to prevent a home foreclosure, because the lender believes that it will result in a smaller financial loss than foreclosing. The decision to proceed with a short sale represents the most economical way for the lender to recover the amount owed on the property. In contrast to a foreclosure, if the borrower has been making payments up until the time the short sale is approved, the short sale may not adversely affect the borrower’s credit report, because the lender has agreed to discount the loan.
Source: Real estate finance and investments / William B. Brueggeman, Jeffrey D. Fisher.—14th ed. p. cm.—(The McGraw-Hill/Irwin series in finance, insurance, and real estate) ISBN-13: 978-0-07-37733-9
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