Dropping subsequent mortgages when upside down

By From page C3 | December 22, 2012

Q: Hi Mr. Jones.  I’m a very long-time reader, but a first-time writer.  I’ve always appreciated the great, practical advice you give. Now I need some.
Like everybody else, my house is upside down. I owe about twice what the place is worth. I have three mortgages, with the last one being a line of credit I got back in 2006.
I work for the county and so my income is going to go down a lot next year. I was barely keeping my head above water, and these furloughs are going to drown me. I need to get out of this house or at least cut my payments drastically. I know you aren’t a big fan of loan modifications, so I’m not really asking that question. But a friend of mine came up with an idea. She suggested that I keep making my mortgage payments to my first mortgage and just stop making them to the second and third mortgages. She apparently heard about this on some radio talk show. How would this work? Do you advise it?
A:  Well, not to be too cynical, but what I advise is not taking legal advice from a talk show radio personality.
The truth is that I hear this all the time. And while it may be good advice for a few, like those who know they’re going to die soon or be moving to a nonextraditable country in the next year or two, for most people it’s a mistake.
First, you have to understand the basic underlying legal principle. In California, when someone has a lien on your property they must foreclose on before they can sue you for any balance that’s owed. Known as the One Action Rule, it has the unintended consequence of preventing second and third mortgage holders from going after any money when you’re in a real estate market such as exists today.
A simple illustration would be valuable here.
Let’s say homeowners Bob and Carol have three loans on their house. They owe $200,000 on the first, $100,000 on the second, and $50,000 on the third.
And let’s assume for the sake of argument that all three loans are recourse loans, meaning the banks will ultimately be allowed by law to sue Bob and Carol for any money they lose.
Now, if the home is currently only worth $150,000, it’s not even worth what Bob and Carol owe on the first. This is an extremely common situation. So, let’s say Bob and Carol stop paying the second and the third. The first won’t foreclose because they’re getting paid. The second and third won’t foreclose for two reasons. First, they would foreclose and have to give all of the money to the first mortgage. They’d get none of it, not even their expenses. Second, under California’s nonjudicial foreclosure law, the bank that actually does the foreclosure becomes a nonrecourse loan. So even if the second foreclosed, all that would happen is they’d have to cough up the money to the first mortgage and would then be prevented from suing. So what would be the point?
The simple answer is that paying only the first would keep you in the house for, maybe, many years with a much lower payment, although your credit would continue to plummet.
However, and this is where the death or leaving the country scenarios come in,  sooner or later the house will appreciate to something above what you owe to the first. At some point, likely many years from now, the second will foreclose. So what you’d really be doing is forestalling the inevitable.
That may sound good right now, but, unless you die or leave the country, you will ultimately suffer a foreclosure and lawsuits. And probably long after the economy is finished healing and nobody is losing their home to foreclosure anymore. That would leave you with the option to file for bankruptcy protection.
Today we have the option to short sell our upside down homes. Short sales are temporary. Believe me when I predict that when the economy improves, short sales will go away. I know because I saw the same thing happen 20 years ago.
If you need to get out from under your mortgage, there is no better time than now. The new short sale laws on the books that I’ve discussed in other columns will protect you from lawsuits. Plus the minute the property is gone you can begin to rebuild your credit and possibly buying another home while the prices are still low.
So the decision you’re playing with is, in my professional opinion, far more complicated than the talk show person suggested, and you need to consider all of the consequences very carefully.

Tim Jones


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