The house across the street has sat empty for the better part of a year. According the neighborhood gossip, the owners—a young couple with no kids—walked away from the underwater mortgage. Apparently, the husband, who worked as a manager for a national restaurant chain, was transferred to another part of the country, and the couple figured it would be easier for them to simply mail the keys to the bank rather than deal with the financial headache.
There has certainly been a great deal of tut-tutting in the neighborhood over this (alleged) decision. But it got me wondering what this couple will deal with (other than our neighbors’ scorn) because they decided to default on their loan. If you are in a similar situation—where you can’t afford to continue paying your underwater mortgage—please know that walking away can seriously affect your financial future. Not to mention your standing in a neighborhood:
How a Foreclosure Affects Your Finances
1. Your credit will take a hit. This is the most obvious consequence of defaulting on a mortgage, and one that many desperate homeowners are willing to face. It’s important to note that after a default, your credit score will not only go down, but you may also find that your credit cards are canceled or have their limits lowered. You can also put your plans for buying a car or furniture on hold unless you can pay in cash, as it will become very difficult to obtain financing on big ticket items. Finally, it will be anywhere from three to seven years before you can qualify for another mortgage.
However, remember that non-default options can also negatively affect your credit. If you agree to a short sale—where you keep possession of the house and maintain it while trying to sell it on the bank’s behalf, generally within a two to three month time frame—you also will see repercussions in your credit score. The difference is that you will be able to apply for a home loan again sooner.
2. You may have to pay the difference between what the bank was able to get for your home and what you owe. This is called the deficiency, and in most states in the union, it’s perfectly legal for your lender to sue you for that difference. Again, this is a possibility even if you go through a short sale, so know that being underwater does not leave you many good options.
Even if you live in one of the few states with anti-deficiency laws, you may still be liable for the difference depending on if you have taken out a second mortgage, if you have refinanced to take cash out of your home’s equity, and if you are still paying your original mortgage. No matter what your situation, if you are considering defaulting or short selling, you will want to consult with a real estate attorney to determine how best to protect yourself.
3. You can’t escape the Tax Man. When the mortgage crisis first hit in 2007, the Mortgage Forgiveness Debt Relief Act was created to offer protection to troubled homeowners—including forgiving federal taxes that would otherwise be due on a foreclosed home. Unfortunately, state taxes do not have to follow this law, and so walking away from your home may burden you with a state and/or local tax bill. The tax liability when defaulting on a second home or an investment property can be even higher.
The Bottom Line
If you’re in trouble, it’s time to call in some experts. Consulting with a real estate lawyer and an accountant may seem like more money than you can afford when you’re possibly facing a major financial crisis—but the cost of a mistake could be even greater than their fees. You want to know exactly what the consequences of your actions will be before you make a decision that could still cost you for years to come. They may also be able to direct you to some programs which may help.
Photo credit: Adam Melancon