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Columns: Bankruptcy Adviser
Justin Harelik   Expert: Justin Harelik
Bankruptcy Adviser
Free-falling home price, rising debt anxiety
Bankruptcy Adviser

Short-sale risks

Dear Bankruptcy Adviser,
We have had our house for sale for three years. We have a first and second mortgage on the property, which has now dropped by more than 50 percent in market value. So we owe more than we can get for it. We have an offer for a short sale approved by the lenders for both the first and second mortgages.

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The first mortgage lender will guarantee to write off the balance. However, the second will not guarantee to us in writing that they will not come after us for the balance owed. I have heard from everyone that they will come after us hard -- garnish wages and call five times a day. Any advice would be great.
-- Simpkins

Dear Simpkins,
You are right to be very concerned about the second mortgage lender. We tell clients with all sincerity that they could face a lawsuit. I wish there was more concrete information to provide -- like which companies are more likely to sue than others -- but no such information exists.

Right now, property values in many major metropolitan areas are dropping about as fast as they rose. The 20 percent annual increases over the past six or more years are being met with 20 percent annual decreases. We are seeing homes purchased in 2006 for $400,000 valued at $200,000 fewer than two years later!

While many industry professionals believe that a short sale is better than walking away from the house, you are learning about short sale risks. The second mortgage lender will not guarantee that you will not be sued for the balance.

There are two major risks with short sales:

1) Will you inadvertently agree to pay back the lender? Lenders who hold wholly unsecured second mortgage loans (aka deficiency mortgage balances) may require borrowers to contractually agree to pay back the deficiency balance after the short sale. This means that in order for the lender to sign off on the short sale, you have to agree to pay back the amount that they will be losing. Make sure you thoroughly review the documents prior to signing them.

2) Will the lender sell the balance to a third party collector? One of the reasons I believe you cannot get a "no lawsuit" guarantee is because the lender might sell your loan. There are debt buyers that will purchase the deficiency balance for pennies on the dollar. That company will try to collect from you directly through any legal means possible -- lawsuits, followed by wage garnishments or bank levies.

Some states, like California, have anti-deficiency laws. These laws protect some homeowners from lawsuits. If the homeowner purchases a house, but never refinances the loan, then the lender cannot sue the homeowner after foreclosure or short sale. As always, there are exceptions for fraud or deceit on the part of the borrower.

There is a significant caveat to this rule that most homeowners do not know about. Once you refinance the loan, you voluntarily (and usually, unknowingly) waive the anti-deficiency protections. This means the mortgage company could sue you for failing to make your payments.

Simpkins, make sure you do not act hastily in an attempt to complete the short sale. Protect yourself and your future with the proper diligence to get the best possible result out of a very difficult and stressful situation.

Bankrate.com's corrections policy -- Posted: July 1, 2008
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