Underwater? Negotiating a Settlement On a Second Mortgage

CoreLogic has found that 38% of homeowners with second mortgages (including home equity lines of credit) are “underwater,” or owe more than their home is worth. Charles Phelan, founder of SecondMortgageAdvice.com has been advising debt-burdened consumers for years and has been observing a recent trend where lenders are more willing to negotiate settlements on second mortgages. In fact, he’s seeing settlements as low as 10-15 cents on the dollar in some cases.

“It’s not a guarantee,” he warned. “It’s situational.” What kinds of situations might lead to a settlement on a second? “The main thing is that the first mortgage has to be seriously underwater. If there is any equity at all in the second, (lenders) are going to want to get it,” he says. An appraisal that shows that the first mortgage is underwater can be a powerful tool, says Phelan. At that point, the second is essentially unsecured, and the lender may be eager to get something rather than risk losing everything if the home goes to foreclosure or the homeowner files for bankruptcy.

Another condition? The loan will have to be delinquent before the lender will consider negotiating. Lenders don’t typically settle on loans that have been kept current. (There is no guarantee that falling behind will result in a settlement, however, so don’t stop paying just to try to reduce the balance on a second mortgage).

In some instances, Phelan says it may be possible to stay in the home and still negotiate a settlement of the second or a deficiency. But typically a settlement occurs with a home that is in foreclosure or being sold through a short sale. (A deficiency is the difference between the balance owed, including fees and foreclosure costs, and the amount recovered through a short sale or auction of the property.)

Why settle at all? Why not just let the home go and forget about the unpaid balance? Phelan points out benefits to settling the debt. “It resolves it on their credit reports,” he says. Plus, he’s worried that the unpaid debt could come back to haunt homeowners in the future. “I see these unresolved deficiencies as a real problem,” he says. “In some states the statutes of limitations are very long. I have this sense that this is the front of the tidal wave and there is going to be a lot of debt purchasers buying these portfolios and trying to collect using aggressive collection methods.” Phelan notes that the only downside to settlement of an underwater second mortgage is the potential income tax liability on the forgiven balance, which may apply to consumers who do not qualify for the insolvency exemption permitted by the IRS. He cautions that consumers should also take this factor into account before agreeing to a settlement on a second mortgage or HELOC.

Of course, if you are considering settling a home equity loan or line of credit, you’ll also want to talk with a bankruptcy attorney to find out whether bankruptcy would be a better option for reducing or eliminating that debt.

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