Should Lenders Pursue Homeowners Who Abandon Ship and Walkout on Their Home?

by tammy on July 6, 2010

After the collapse of the American residential property market in 2008, many people got caught holding housing and owing on mortgages that were worth a lot more money than the actual property was worth. In fact, in some major residential markets like Florida and California, many homeowners saw their property decline in value by more than half the amount they originally agreed to pay for it. In such an instance, it is frequently in the borrower’s best interest to simply walk away from the mortgage and allow the lender to foreclose upon, repossess, and resell the property.

Obviously lenders really hate it when borrowers default on their mortgages, especially since with the readjustment of the property values there is almost no possibility that the lender will be able to resell the property at the pre-2008 price. As a consequence, lenders deliberately employ a number of scare tactics in order to scare people away from defaulting, although in reality defaulting would make the most financial sense for them. Generally speaking, if a borrower opts to cut his or her losses by walking away from a house that they cannot afford, the loan will go into default and the lender will foreclose, retake possession of the house and then try to resell it to a new person. When this happens, the lender has two options: it can pursue the borrower for the amount lost in the default (the difference between the original mortgage amount and the amount the lender was able to resell the house for) or the lender can swallow the loss itself, with consequences to the borrower.

If the lender chooses to actively pursue the borrower, it generally involves considerable court expenses and an extensive legal process. This means it is rarely worth the effort unless the borrower has an significant income and large asset holdings that is worth enough to not only offset the loss from the loan default, but also the associated legal expenses. Obviously if the borrower has a very small income and few – if any – assets (or only assets that would be exempt in a bankruptcy), then it is usually not in the lender’s best interest to actively pursue the borrower. However they may still employ harassment techniques via collection agencies and generally make the borrower uncomfortable even if they are not willing to go to court.

If legal action does not makes sense – as is often the case with many people that walk away from their grossly overvalued mortgage loans – the alternative is for the lender to write-off the loss. The lender is able to write-off the difference between the amount of the original, defaulted loan and whatever amount they were able to recover through reselling the property. This write-off counts against their tax liability with the Internal Revenue service (IRS) and they also issue the defaulting borrower a 1099 form which treats the loss amount as taxable income to the defaulting borrower. Under normal circumstances this could be a disaster for many borrowers since their tax bill suddenly skyrockets and tax debt cannot be discharged through bankruptcy. However, Congress recognized this problem in the wake of the housing collapse and has passed legislation eliminating this tax liability on borrowers due to mortgage default until 2012, so this is not really an issue for the time being.

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