Rebuild credit after loan default

Refinancing complicates debt forgiveness

Tom Kelly
Inman News

Our four children and their academic calendars have guided me through time in four-year blocks. For example: "Charley was a sophomore when that happened. He’s been out for two years so it must have been four years ago."

That’s how I remembered my friend’s situation while visiting at a recent high-school game. It’s been four years since the man lost his longtime job, sold his house at a loss and then had to pay tax on the mortgage amount forgiven by the bank.

The net amount forgiven, $15,000, showed up as taxable income on the homeowner’s tax return.

A few months later, the Internal Revenue Service changed the law regarding debt forgiveness, allowing thousands of borrowers since then to avoid paying tax on a short sale or a foreclosure proceeding otherwise known as the "cancellation of indebtedness income."

According to Everett resident Rob Keasal, a partner in the Seattle accounting firm of Peterson Sullivan LLP, the indebtedness relief benefit applies only on a primary residence — not second homes or investment properties — and is limited to the first $2 million of mortgage indebtedness on foreclosures on or after Jan. 1, 2007, and before Jan. 1, 2013.

The confusing part, however, is that refinances made between the time of purchase and foreclosure could cloud the waters.

For example, if you refinanced your loan and took cash out of the property to pay for cars, vacations and other real estate, the amount of your loan when it went into foreclosure could have been far greater than the original debt.

The relief limit stops at the amount of the original debt, minus what you have paid in principal. Money borrowed for capital improvements can be added to the original debt figure.

In other words, borrowers should look at the relief debt as purchase money debt, unless the refinance money was expressly used to improve the primary residence.

Many borrowers are now facing higher payments and possible default and foreclosure resulting from the upward adjustment of an adjustable-rate mortgage.

Whether it is a conventional adjustable-rate mortgage leaping to a higher rate, or a subprime loan tied to a high-interest-rate second mortgage and a prepayment penalty, the possibility of a home-sale loss or short sale is higher now than ever.

Given the occurrences of the past three years, many lenders will bend over backward to help borrowers who are behind. Some banks have long-standing alternative loan payment programs available while others have installed new packages.

Alternative programs for mortgage payments are typically lumped into one category: "forbearance." Forbearance is not free, nor does it mean forgiveness.

It usually is a short-term agreement between borrower and lender permitting partial payments until normal payments can be resumed. Typically, forbearance agreements run three to six months.

Credit reports will show delinquent payments when full payments are not received. If you make partial forbearance payments for a short period, it’s best to petition credit bureaus to remove any "black marks" after full payment has been made. Explain the circumstances to the credit bureau in a letter to protect your future credit.

Forbearance does delay foreclosure, the process by which a homeowner who has not made timely payments of principal and interest on a mortgage loses title to the home. The foreclosure clock starts ticking once the borrower is in default.

A borrower technically is in default one day after a payment is due. However, most lenders do not mail the borrower a notice of default until two to three payments are missed.

Most mortgage bankers do not eagerly await a default on the family home. Lenders are in the business of loaning money and they do not wish to have your home back. It takes considerable time and money (about $100 a day) to manage and maintain foreclosures. Lenders would prefer to spend their energies on processing applications and recruiting customers.

My friend has landed a new job, is renting a nice home and plans one day to buy another house. Even if he were able to delay his home-sale loss to take advantage of the mortgage forgiveness law, it would have done nothing to help with his credit.

"You have to start over with the credit reporting agencies," he said. "But having a job makes everything possible. It just will take a little time."

Tom Kelly’s book "Cashing In on a Second Home in Mexico: How to Buy, Rent and Profit from Property South of the Border" was written with Mitch Creekmore, senior vice president of Stewart International. The book is available in retail stores, on and on

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Copyright 2010 Tom Kelly