If you all of a sudden got the money to pay off your home and get out of foreclosure would you? Why or why not?
The answer to this question is sufficiently complex that it defies a ready answer in a single post. Mr. Roper has discussed this before in other threads. Scroll back and maybe you will find the discussion. Someone good at searching might find these posts more easily.
Mr. Roper makes a good argument that the analysis should begin with an economic assessment of the borrower's financial situation, with a primary focus on the borrower's net equity in the property. The borrower's other financial circumstances are important, too.
Where there is equity to protect, finding a way to get current is usually a good idea. Where there is substantial net negative equity, walking away from the property may be preferable. This might involve a strategic default. After default, the question is presented as to whether to fight the foreclosure or to settle, as with a short sale or deed in lieu. This is also an economic decision.
Defaulting has other consequences, including negative impact on the borrower's credit. There is a value to having good credit, which ought not be discounted or taken lightly.
But if a borrower is facing a variety of other debt related issues that might require a bankruptcy anyway, then staying current or paying down the mortgage really isn't going to resolve the negative credit problems.
Sometimes when assessing possible alternatives or understanding principles, it helps to construct extreme examples. Permit me to furnish two.
First, suppose that a borrower has a $300,000 mortgage note on a property now worth only $100,000. Further suppose that the borrower has an additional $100,000 in unsecured debt. And suppose that this same borrower has $150,000 in an IRA or other similar tax preferred retirement plan.
Finally, let us suppose that the borrower has lost his job, has little near term prospect to get another job to restore income and cash flow and is already seriously delinquent on both the mortgage and the unsecured debt.
One choice would be for the borrower to use the money from the IRA to bring the mortgage current. This could even be done within the context of a loan modification agreement, etc.
But the end state is going to be drawing down both a tax preferred investment (possibly incurring a substantial tax liability) to fund a mortgage that is underwater by $200,000. This borrower still faces severe credit impairment due to the default on the other unsecured debt.
By contrast, if the borrower files for bankruptcy, the $100,000 in unsecured debt can probably be wiped out. The $150,000 in the IRA is likely to be exempt in the bankruptcy. If the borrower can arrange a deed in lieu or short sale with a waiver of any deficiency by the lender, the borrower extinguishes $300,000 in debt.
The borrower might lose the property, but wipes out a total of $400,000 and still keeps the $150,000 in retirement savings.
Alternatively, the borrower could first contest the foreclosure, live in the property possibly payment free for two to five years and then later declare bankruptcy after ultimately losing the house in foreclosure. In this instance, the borrower probably obtains an additional $20,000 or more in fair rental value of the property during the interim, though at the cost of dragging the matter out and deferring and extending the credit damage.
If, instead, the borrower draws down on the retirement funds, a more likely outcome is probably going to be the bleeding dry of savings, but the ultimate loss of the property to foreclosure. Bear in mind that this property is still underwater by $200,000 and is unlikely to recover this value within the next two decades.
Compare a second situation where a borrower has a $100,000 mortgage on a $300,000 property, no unsecured debt, good credit and a job with some income. Further suppose that this latter borrower has reasonably liquid investments which are not in tax advantaged retirement accounts.
Right off the bat, it is easy to see that in falling behind in his mortgage, this latter borrower places $200,000 in equity at risk. There is no other debt to extinguish in bankruptcy, but even if there was, the $50,000 in liquid investments would ordinarily be at the trustee's disposal to use to pay down debts.
This person could suffer very severe losses in equity by defaulting and remaining in default. This borrower would not be a very good candidate for bankruptcy.
These are stark examples. Most borrowers will fall somewhere between these extremes.
Instead of having substantial negative equity, a borrower may have thin or only slightly negative equity. Instead of having really substantial unsecured debt, a borrower may have modest levels of such debt. A borrower might have some limited credit impairment. A borrower may have various assets some of which are going to prove exempt in a bankruptcy and other assets that are non-exempt. What is exempt varies from state to state.
The bottom line is whether it is better for a borrower to default or cure depends upon a wide range of borrower situational inputs. Every borrower ought to identify several alternatives and then try to assess the various relative cash flows and costs of each alternative. These should then be compared. Because foreclosure timeliness vary from place to place and the prospects of forestalling a foreclosure are highly dependent on the legal framework and environment, especially whether a state is a judicial or non-judicial foreclosure state, an otherwise similarly situated borrower might face vastly different outcomes and incentives in different places.
In non-judicial foreclosure states, very often bankruptcy is the only venue where a borrower is likely to forestall a foreclosure for very long. So borrowers in such places need to assess whether they can benefit from a bankruptcy and whether they are better off filing sooner or later.