Understanding Defaults and Foreclosures

Have you heard the terms "default" and " foreclosure" in the news recently? These are two more words along with "bubble" and "soft landings" that are going to get a lot of press over the next few years. It might be helpful to understand more about them because they represent both pain and opportunity.

Please note: This process varies from state to state, and I am not a lawyer. This is intended as a general discussion, not legal advice, for which you should seek the counsel of an attorney.

At its heart, a mortgage is a contract between a borrower and a lender. The lender gives the borrower money and the borrower says he will pay it back.  In addition to his promise to pay, the borrower also gives the lender a "security interest" in his property, otherwise known as a secured loan.

The secured loan is vitally important to the lender. Quite frankly, lenders would not lend much money to people based solely on their pledge that they will repay what they borrowed.  Most borrowers simply do not have the creditworthiness and assets needed to support a large unsecured loan. The lender wants recourse, and that recourse is the ability to take over the property should the borrower not live up to his agreement.

Note that in many states, you really don't have a mortgage but instead a "note secured by a deed of trust." When this happens, the borrower signs a promissory note. This additional document spells out how the lender can enforce his "security interest" in the property – i.e. how the lender can take the property away from you!

If the borrower doesn't live up to his agreement, such as not making payments or not paying property taxes, those are "events of default" which trigger the lender to start looking out for its interests. When a lender is convinced that the borrower will not comply with the agreement, he files what is known as a Notice of Default. 

This notice starts the clock ticking. The procedure after this varies greatly. But in all cases, at some point in time, the lender will end up owning the property and will try to sell it to someone else.

Now, when you read of an increase in defaults, this does not mean that the lenders have taken back all these homes. It just means that they have started a legal proceeding to do so. In fact, buyers have a number of options open to them if they are in default. Many will be able to resolve the problem on their own.  For example, someone may have lost a job and fallen behind in payments, but with a new job he can assume making payments again.

Other borrowers are smart and contact the lender to see if a revised payment schedule can be worked out. Believe me, the lenders do NOT want to take houses back, and in all likelihood, will be open to developing a reasonable plan. I hear reports that many borrowers just assume that lenders won't work with them. That's a BIG mistake.

Still others will realize that they can never make the monthly payments, especially if the payments have increased significantly from when the home was purchased. If a borrower lives in an area where there has been good appreciation, he or she can put the home on the market, sell it, and get whatever equity is there and start over.

Of those loans that go into default, only a relatively small percentage actually go to foreclosure. Most people are successful in finding a solution, like the options we listed above.  The actual foreclosure rate is only a little over 1% for A-paper (good credit) loans and around 6% for subprime (bad credit) loans.

So when you see a newspaper headline about default rates, you now understand that it does not mean that all those people have lost their homes. Just that they have probably missed some payments and could be in trouble.

For new buyers, there are opportunities created by an increase in default rates. Unlike other sellers who aren't in a rush, these default owners might be more willing to take a lower price. Especially if they are getting close to losing their home. If you are thinking of buying an investment property, this would be a good place to start.

If you are interested in learning more about this process, there are a number of websites where you can sign up to be notified about homes that are in various stages of the default and foreclosure process. Perhaps your next investment will be to buy one of them.

In the meantime, if you are one of those people who is flirting with default, contact your lender right away and see what kind of program you can work out with them. One simple phone call could be the difference between keeping and losing your home.