How to get out from underwater ethically?

Question

I'm new here...Our house is underwater by more than $200k.  There's no sign of it being anywhere near what we owe on it, let alone 20% over in order to refinance in 3 years.  Yes, this was a 100% financed, 7 year locked ARM with a 15 year second.
To say the least, we want out.  We made a good financial decision and can still afford the mortgage.  Foreclosures have brought down the prices drastically.  Why should my wife and I be punished for bad decisions others made?  This was out of our control!
So, the deal is we can afford to purchase a second home that would be bigger and much cheaper.  I just don't want to dump the underwater house, but we couldn't even get half of the expense of it from rent.  So what can we do that is ethically right to get out of the first house after we buy the second?

James Harkness · Answer

There is nothing that you can do that is ethically "right" other than pay back your mortgage at the current terms if you can afford it.  Housing prices always fluctuate, and you never hear people complain when their house appreciates in value.  You also never hear of banks reassessing the Principal balance of the loan (by increasing) because a property appreciated in value.

Wait it out and the value of your house will once again appreciate some day.  Why is it that you were happy with the deal you got a couple of years ago but now don't want to pay?  Your home didnt change materially, did it?  Its still the same house, right?

Jon Holdman · Answer

If you try to buy a second house, the lenders will require you to qualify for both loans.  They won't believe you're going to rent out the old one.

I'm with James, why was this house a good deal when you bought, yet its not now?  Every time anyone buys a new car they KNOW they're going to be underwater as soon as they drive off the lot and for most of the time you have the note.  Yet everyone assumes house prices will go up.

The only ethical thing is to pay off the loan. You didn't put up a down payment up front, so you're going to have to put up one on the back end.

Now, if you're willing to take the hit, walking away is an option.  It's not the ethical thing to do, but it may work out better for you financially.

The lender may come after you.  If you have income and assets, and you live in a state that allows deficiencies, the lender may try to collect.  The forgiven debt may also be subject to taxes.

Jon Holdman · Answer

Interest only means there is no principle payment.  So, unless you've made extra payments, there's been no principle paydown at all.

Borrowing 100% of the price (plus closing costs?) with an interest only loan is an insane way to buy a house.  The fact you could get this loan is an indication of how stupid lenders were during the boom.

The reality is that you didn't buy this house at all.  You rented it.  The rent is equal to your payment.  You bought a house you couldn't afford.  Afford means you could have put at least 10% down and got a 30 year amortizing loan.  Or, if you could have afforded to do that and didn't, then you used the money for something else.  So now the landlord is here to collect (i.e, your ARM is resetting).  You've lost your bet, and make no mistake, it was no different than throwing down a black chip on a craps table.

The payment will be much worse than just giving back the house.  At the very least your credit is going to be wrecked.  If you do a short sale, it will be two years after that before you can get another mortgage.  If it goes to foreclosure, that's five years.  Depending on your state, the lender may come after you for a deficiency.

If you try to buy another house, you'll have to qualify for both loans.  If you do that, and move into the new one, you may give up the "benefits" of losing your primary residence through foreclosure.  Specifically, there is a fairly recent law that allows homeowners who lose their primary residence to avoid the tax on the forgiven debt.  Normally, if you owe (say) $600K and the house is now only worth $400K, then the $200K in forgiven debt would become taxable.  As far as the IRS is concerned, its equivalent to having been given a check for $200K (which it is, the check was just given to the seller back when you bought).  This law avoids that tax.  But it only applies to primary residences and only to the acquisition or improvement debt.  If you go buy another house, this will turn into an investment, and you may lose the ability to avoid that tax.  Not an expert and not a CPA. In your shoes, I'd surely spend some time with a CPA before doing this.

Now, maybe you can get the lender to modify your loan so that it is amortizing and at a fixed rate.  Today's rates are very low.  You might even qualify for the new principle reduction programs.

In time, with an amortizing loan and inflation, you will get back above water.  That's the ethical thing to do.

Bill Gulley · Answer

Hi, that is under the default provision of the security agreement, not the note. If you default in your promise to pay as agreed the security given as collateral may be seized and sold to cure the default.  If you have a standard deed of trust used by institutional lenders, it does not say "the property must be forfeited" to cure the debt, it is only a "must be forfeited" situation when the sherriff comes knocking. There is no "must be forfeited" in a foreclosure that comes after the property has been sold. Now, the lender has the OPTION of accepting the property in lieu of payment of the debt. This varies state to state and depends on deficiencies allowed. The lender can accept the property instead of going to foreclosure, it's a deed-in-lieu-of-foreclosure.

But all of this still comes after breaking your promise to pay as agreed. I think what you're wanting here is a reassurance that walking away is ethical, you won't hear that from me if you have the ability to pay the obligation! What if you had loaned money to someone who bought an house, what would you want them to do under the same circumstances? Good luck, Bill

Bill Gulley · Answer

Hi, just 2 cents worth; when you buy an investment there is no guarantee that it will make you money. When you buy a house, there is no guarantee it will make you money, but it serves a basic need. If you BORROW money to buy either one, you owe that amount regardless of what your investment does or what benefit you gain from the property. The promissory note says something like; "the undersigned promsies to pay to the order of", in other words you gave your word, your promise to pay.

The lender gave you the money you wanted, what you do with that money is irrelevant! If you had bought penny stock with it and the value went down, do you think the lender should just say, ahh, that's OK, we know the market went down and we thought that was a good stock pick too, we'll just write off what you lost and we will continue in the lending business.

How ever you want to justify it, you borrowed the money, you promiseed to repay it, so tell me, what is ethical?

Now, if the effects of the economy have put you in a position where you simply can not follow through with your promise, it is really at no fault of your own. There are laws to protect you in such situations and assist with such debts.....it's called bankruptcy, it's part of the rules to the game! Good luck, Bill

Jon Holdman · Answer

You made a bet.  That bet was that your house would appreciate enough to refinance before your crummy loan really became a problem.  You make a bet that you could get another 100% loan or that you would get enough appreciation to get a decent LTV.

Sorry, but you lost that bet, and you're going to have to pay somehow.  Sadly, you're not the only one to get caught up in those bets.

Since you talk about an ARM, was this a pay option ARM?  Is some of that $200K in shortage a result of you paying less than the interest payment?

Brian Levredge · Answer

I think your biggest mistake is looking at your primary residence as some sort of investment.  It's not, nor should it be.  When you factor in all the expenses of owning a home as a residence,  they don't add up in your favor.  Ethically, there is no way to get out of your mortgage, short of paying it off.  You could try to see if the bank will modify it or if you can short sell the house and take back a loan for the unpaid principal.

Brian Haskins · Answer

I'm not sure if there is an ethical way. If you can still afford the home. I guess it just depends on what you feel is ethical. You might be able to do a loan modification to get the price down or possibly an internal refi. Your in a situation with a lot of other people.

Brian Haskins

Rich Simpson · Answer

freedomwest, I don't see any signs that the market will recover to what it once was...at this point, I don't think I have a choice.  It's not going to recover for years!

Kathryn K. · Answer

I bought my home in 2004 at a price that was below market and put 25% down on a conventional loan and the house is now 150K underwater.  I didn't buy a house I could not afford. I put up a good down payment and thought I made a good decision and I'm still in the same position as Rich, so I kinda sympathize.  I only intended to live here for about ten years and I'd like to move in three more years, so I am faced with the "hang on for the long term" or dump it before the homeowners exclusion exemption runs out in 2012. Rich, can you hang on until the market recovers or would you prefer to shortsale it?  As someone else pointed out, a shortsale will affect your ability to get another loan for two years, but it won't damage your credit that much.  You do  have to demonstrate some kind of hardship. Being underwater is one of them, however if your income is substantial it may not be enough.

How to get out from underwater ethically?

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