What to Do When the Sale Price of a Home Does Not Pay Off a Mortgage

Once a price decline gets underway many buyers who were late to the price rally find they are in a property worth less than they paid for it. As prices continue to fall, many find themselves "underwater" owing more on their mortgage than their property is worth. When these late buyers want to become sellers, they cannot sell and pay off the mortgage balance with the proceeds from the sale. Then they have a real problem. It is a problem with only 4 plausible solutions:

1. The borrower can keep making the mortgage payments until prices go back up. This is the "hold and hope" strategy. If the borrower uses exotic financing, which most buyers did in the later stages of the Great Housing Bubble, it may be difficult to continue making mortgage payments because these payments are likely to increase substantially. If the property is not owner-occupied, the borrower may try to rent it out to cover expenses; however, this is generally not feasible. Buyers who purchased during the mania paid too much money relative to prevailing rents and available income. If this were not the case, it would not have been a financial mania. Since the payments are too high, renting the property does not cover the expenses. Renting out the property lessens the pain, but it does not make it go away. Also, since housing market corrections often last 5 years or more, it may be a very long time before prices recover to peak bubble levels. Keeping the property is a "death by a thousand cuts," or perhaps a death by a thousand payments.

2. The borrower can write a check at the closing to pay off the portion of the mortgage not covered by the proceeds from the sale. Many people do not have the amount necessary in savings, as few thought such a loss was even possible, and even fewer are willing to go through with the sale knowing they will have to pay for the loss. The undesirability of this option usually forces the borrower to keep the property and try to endure the pain, or let it go up for auction at a foreclosure.

3. The borrower can try to convince the lender to agree to a short sale. A short sale is a closing where the lender accepts less than the full mortgage amount at the closing.

4. The borrower can simply stop making payments and allow the property to go to public auction in foreclosure. Both short sales and foreclosures have strongly negative impacts on credit scores and the availability of credit in the future.

In the price declines of the early 90s, most people opted to keep making their payments and stay in their homes. Downpayment requirements were high, and the use of exotic loan programs was less common in the preceding rally, so many homeowners had equity in their properties and were able to make their payments. They accepted debt servitude as part of the price of home ownership. When faced with the four options presented to them, most chose to stay in their homes and keep making payments.

As the slowdown in the housing market helped facilitate a recession in the early 90s, a recession compounded in California with defense industry layoffs, many people lost their jobs and as a result, lost their ability to make high mortgage payments. This created a problem with foreclosures that pushed prices lower. The decline in prices in the early 90s, though extreme in certain fringe markets, was not so deep to cause many people to voluntarily walk away from their mortgages. Most buyers during this period were required to put 20% down. This represented years of savings and sacrifice for many, so they were not willing to lose it. Since the total peak to trough correction was a bit less than 20% statewide in California and even less in other states, many homeowners still had some equity in their homes. The combination of high equity requirements and a relatively shallow correction made staying in the home the best choice for many. This kept foreclosures to high but manageable levels. In contrast, the Great Housing Bubble was characterized by low or non-existent equity requirements, and very steep initial drop in house prices. These conditions made foreclosures, both voluntary and involuntary, a tremendous problem.

Much of the purchase money in the bubble rally was debt. As 100% financing became common, the average combined loan-to-value on purchase money mortgages climbed to more than 90% (Credit Suisse, 2007). With so many people with so little in the transaction, it did not take much of a price decline to cause people to give up. By late 2007 prices had already fallen 10% or more in many markets, and there was no sign this would change in the immediate future. It was becoming obvious that those with little at risk were well underwater and they were going to be that way for the foreseeable future. This inevitably led to one of the unique phenomena of the Great Housing Bubble, Predatory Borrowing.

Many simply stopped making payments they could afford because the value of their property had declined significantly. Nowhere in the terms of the mortgage did it state the payments would be made if, and only if, resale values increased, but many borrowers acted as if it did. When borrowers quit making payments they were capable of making simply because they were not going to make money on the deal, their behavior was predatory to the lender who ultimately had to absorb the loss. These borrowers often had so little of their own money invested in the form of a downpayment they felt little actual damage from just walking away from the property and mailing the lender the keys. Many borrowers simply stopped making payments, did not respond to letters or phone calls from the lender, and moved out. Short sales and foreclosures were not the end of the nightmare for sellers. It is the last contact they had with the property, but in many circumstances the debt, and debt collectors, followed them until the debt was repaid or discharged in bankruptcy.