Foreclosure 101: How to Protect Yourself

Buying a home is typically a happy milestone. You’ve crossed a major threshold. You’ve achieved a life milestone. You feel optimistic and confident about the future.

I don’t mean to throw cold water on your party, but I’d like to extend a note of caution.

The reality is that millions of homeowners have wound up in foreclosure. Many of these people once felt as happy and optimistic about their purchase as you do. After all, when you purchase a home, the idea that that house might one day be subject to foreclosure is perhaps the last thing on your mind.

How can you avoid this risk? Read on.

Why Do Homeowners Lose Their Homes?

Most homes fall into foreclosure after the owner defaults – or stops making full payments – on their mortgage loan. How does this happen?

Sometimes, this happens because the owner overextended, buying more home than they could reasonably afford. Likewise, the lender also offered a loan to an unqualified buyer; someone who shouldn’t have been awarded a home loan of that size. (Prior to the recession, many lenders didn’t verify a person’s income before awarding a loan. Not surprisingly, many loan applicants pretended that they earned more money than they actually did.)

Other times, the owner defaults after they’re hit with a series of unexpected life events, such as losing their job or facing major medical bills, which affects their ability to make their monthly mortgage payment.

In some cases, the owner took out a second mortgage and spent the money on liabilities (rather than income-generating assets), which decreased their overall net worth and harmed their ability to repay on the second note.

In other cases, the owner accepts an adjustable-rate mortgage, assuming that they’ll be able to meet the payment obligation if the rate rises. (Federal law requires the lender to disclose the maximum interest rate that the owner might pay under the terms of their adjustable-rate mortgage note.) The owner enjoys low introductory interest rates for a while, but when those rates rise, the owner discovers that meeting those payments is harder than they’d anticipated, and falls into arrears.

And in many cases, the homeowner realizes that he or she is “underwater” on their mortgage (a concept we’ll discuss below) and concludes that walking away is the most reasonable choice.

As you can see, there are many reasons why owners fall behind on their payments.

How Can You Protect Yourself?

Nobody likes to think about the process of potentially facing foreclosure. But we must take a hard look at risk factors that might lead us toward the threat of foreclosure if we want to develop a strong, responsible approach to our personal finances.

In addition, we must also understand how the foreclosure process works so that if our future took a turn for the worse, we would have some idea as to what might lay ahead. This will help us know what other options we can choose from.

Risks That Lead to Foreclosure

Approximately 7 million people lost their homes during the Great Recession, according to CBS News.

While the number of foreclosures has slowed since then, many homeowners are still in trouble. As of the end of 2015, approximately 4.3 million homeowners were underwater, meaning that the homeowner owns a home that’s worth less than the amount they owe on their mortgage.

Being underwater on your home is one of the biggest risk factors indicating foreclosure. After all, if the home is worth less than the balance owed, you may conclude that it simply makes more sense to walk away.

Before you make that decision, though, here’s a word of warning: walking away holds major implications for your credit. It can harm your ability to buy another home in the future, as well as your ability to rent homes, open credit cards, borrow on other types of loans, and even qualify for certain jobs.

What should you do if your home is underwater? You might want to hold onto the home and wait for the property to regain its value. If you need to move, you could rent the home to a tenant. Alternately, if you must sell the home, you could ask your lender for short sale approval (we’ll discuss this below) or bring cash to the closing table.

What if you’re not underwater but you’re struggling to make payments?

First, before you purchase a home, buy a less expensive home than the one for which you qualify. You don’t need to buy a home priced at the maximum amount of the loan that you qualify to receive.

Many people within the real estate industry say that your mortgage itself should gobble up one-third of your take-home pay. This figure doesn’t include repairs, maintenance, utilities and other ancillary costs. However, that figure might be too high. Try this approach, instead: as a general rule of thumb, aim for all of your home-related payments, including utilities, repairs, and maintenance, to come to about 25 to 30 percent of your take-home pay.

On top of that, maintain an emergency fund that covers at least six months of your expenses. Keep this emergency fund in a cash-based savings account, rather than in any types of investments (like stocks). Do not tap this for holidays, birthdays, or annual expenses. Preserve this only for true emergencies.

If you find yourself struggling to make payments, begin drastically cutting expenses in various areas of your life. You’re in the midst of a financial crisis; spend like it. Don’t just cut your cable; sell the entire TV. Don’t just brown-bag your lunch; switch to a college student rice-and-beans diet until you’re back on your feet. Earn extra money in every spare second of your evenings and weekends with freelance work, which you can handle online from home while your children are asleep. See if you’re eligible to refinance into a lower-interest-rate mortgage.

If you fall behind on your payments and you don’t think you can catch up, it’s time to sell your home. Selling your home is far preferable to foreclosure.

If your home is worth less than the amount you owe, you’ll need your lender’s approval for a short sale. A short sale is a sale of the home in which the borrower receives less than they currently owe. The lender loses the difference.

If the lender realizes that they are more likely to recoup their losses through a short sale than through a traditional foreclosure process, they will allow the borrower to proceed with listing their property as a short sale.

Short sales are one way to avoid facing the credit repercussions of a full-scale foreclosure, but they aren’t ideal. Keep this in your back pocket as a last resort.

Next Steps

If you think you may be facing foreclosure, contact our office at (561) 838-9595 for a FREE consultation.

Provided by TheBalance.com