Borrowing a mortgage is a big responsibility. When you’re an investor, lenders take serious precautions to ensure you can afford it, but many borrowers still default.
A mortgage default can greatly hurt your credit and future chances of purchasing real estate, even for your own use.
So what is a mortgage default, and how does it work?
What Is a Mortgage Default?
If you don’t meet the loan terms you agreed to when you closed on your mortgage, you are in mortgage default. The most common way is to miss your monthly principal and interest payments.
Your loan agreement states you agree to make your payments by a specific date each month. If you fail to do this, you are in mortgage default.
Another less common way to be in mortgage default is not to stay up to date on your property taxes or homeowner’s insurance. Your loan agreement states that you agree to pay your taxes and keep your home insured. If you don’t, you default on the mortgage agreement.
A couple of other ways to default include:
- Not properly maintaining the home and letting its value decrease
- Transferring the property deed without lender permission
The Process of a Mortgage Default
Once you default on your loan terms, the lender can take action. They usually don’t do anything until you’ve missed several monthly payments. If you do, they can request that you “cure the default.” There are a few ways they can require this, including making up your missing payments or accelerating the debt, which means you must pay the entire outstanding balance to restore the loan.
If you don’t restore the loan, the lender can start the foreclosure process. Your rights before this happens are laid out in your mortgage agreement. Be sure to read the fine print to see your options to cure the default.
Consequences of a Mortgage Default (Risks)
If you and your lender cannot come to an agreement after going into default, the lender has the right to foreclose on the property. This means the lender takes possession of your home and tries to recoup the funds they lent you.
A foreclosure stays on your credit report for seven years. So not only do you lose the property, but the action damages your credit for many years. Your credit score will likely decrease as much as 150 points, and you may be liable for the difference in the amount the lender gets from the sale and what you owe. They could even sue you for it.
How Does the Foreclosure Process Work?
The foreclosure process varies by state, as each state has different laws, but here’s the general process.
Default
A lender cannot start the foreclosure process unless you’ve defaulted on your loan. They can send borrowers a nonpayment notice after the first missed payment. This is to warn you of your default and the need to catch up.
If you miss an additional payment, they will send a demand letter demanding repayment before they take further action.
Notice of default
If you miss three payments (90 days late), the lender will issue a Notice of Default. This is still a warning and often includes a grace period to restore the loan. During this time, discussing your situation and options with the lender is crucial.
Notice of trustee’s sale
In most states, lenders will hold a trustee’s sale or housing auction. The lender starts the auction with an opening bid that they calculate based on the outstanding loan amount and any unpaid liens, such as tax liens.
If there is a winning bidder at the auction, the bidder takes immediate possession of the property and deed.
REO sale
If the property doesn’t sell at auction, the lender may give it to a real estate agent in their network to sell. The lender may take care of the liens on the property to make the property sell faster.
Eviction
During this entire process, the occupants can remain in the home. When the home sells at the auction or as an REO sale, the occupants must leave, as the property will change ownership.
Impact of a Mortgage Default on a Real Estate Investor
Defaulting on your mortgage affects you differently as a real estate investor. You aren’t losing the home you reside in, but instead the property you own as an investment. This could potentially leave your renters without a place to live and affect your future investment opportunities. Because of the effects on your credit score, it becomes challenging to borrow money for an investment property in the future.
Most lenders already consider investment properties riskier, and if you have a history of default, they either won’t lend to you, or if they do, they will charge much higher interest rates and less attractive terms.
The damage to your credit score won’t affect it for the full seven years it’s on your credit, but the fact that it’s in your history will affect lenders’ decisions.
In addition, defaulting on your mortgage decreases the home’s value, which may decrease the property values in the surrounding area, making the market less attractive.
If you want to purchase another property in the future, you’ll likely have to wait until you have a large down payment or restore your credit. Conventional lenders typically require borrowers to wait seven years after a foreclosure to try again, especially on an investment property.
Tips to Avoid Defaulting on a Mortgage
Now that you know the answer to “what is a mortgage default,” it’s time to learn how to avoid defaulting on a mortgage. While some circumstances are unavoidable, such as divorce, major medical issues, or unexpected death, there are some steps you can take to avoid default, including:
- Make a large down payment: Don’t borrow more than you can afford. Wait to purchase an investment property until you have a sizeable down payment and can keep your mortgage payment affordable and within reason so you still profit on the property.
- Talk to your lender: If you know you won’t be able to make a payment on time, contact your lender. Many offer repayment plans when you experience financial issues. Honesty and regular communication are key.
- Sell the property: If you can’t afford the property or don’t have renters in it consistently, consider selling it. While the process won’t happen overnight, it can prevent you from losing the property in foreclosure.
How Can I Get Out of Default?
If you’re in default, communication with your lender is vital. Once you default on your mortgage, lenders position themselves to start the foreclosure process, but you can stop it with the following steps.
Request a repayment plan
Some lenders offer a repayment plan just for asking and being honest about your financial situation. This may include putting the past due amount at the back of your loan or temporarily reducing your monthly payments to make them more affordable.
Refinance the loan
If you know you can’t afford the loan, consider refinancing. This is best done before you miss a payment, but even afterward, you may be able to get more affordable terms.
Request a loan modification
Many lenders offer loan modifications, which is a change in your agreed-upon mortgage terms. This could include reducing your interest rate or extending the term without refinancing.
Short sale
If you don’t think your inability to make the payments is temporary, ask the lender if you can begin a short sale. With lender permission, you can sell the property for what you owe versus its actual value. The lender forgives the remaining balance, but there may be income tax consequences on that balance.
Forbearance
If you can’t make any payments and the situation is temporary, you may be able to request forbearance, which is a temporary halt to your payments, usually for up to 90 days. After the period ends, you must restart your regular payments and take care of the payments you missed. However, some lenders will tack that amount onto the back of the loan.
Final Thoughts
Defaulting on your mortgage can cause you to lose the property and seriously damage your credit. Fortunately, there are ways to work around it, especially if you stay in contact with your lender. If you notice yourself unable to keep up with the payments, it may be in your best interest to consider selling the property to avoid long-term damage to your credit.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
