Ruthless default or strategic default are terms used to describe borrowers who could continue to make their payments, who decide to stop making payments.  The increasing number of such borrowers is driven by the many people, especially those in California, Arizona, and Florida who owe much more on their house than it’s current market value.  Many of these people are so far “Underwater” loan modifications will not solve their problem.  Many others have lost their jobs.  Without a job there is no modification that will make a difference.

On one side of the discussion are borrowers who feel their loan is a promise they made and their ethics say you must honor your promises.

On the other side are those who say their mortgage is a business contract which can be broken by either party,  subject to known penalties.  (Bank gets the house, borrower gets their credit trashed.)

Lenders greatest fear is that a significant number of borrowers will change from feeling a moral obligation to repay to feeling justified in walking away from their loan in spite of the consequences.

A poster on a forum I read summed up the conflict nicely:

“Strategic default sounds unconscionable until you compare it to killing any chance of retirement, having difficulty putting food on the table, and having no prospect of being whole even if you follow the rules.”

If you sell your property with owner financing that makes you a lender! Since owner financing is frequently used for transactions where the buyers credit is questionable, where down payments are smaller than normal, or where the property is not financeable with a conventional loan, it is even more likely to have problems.  That is not good in todays economic environment.

I strongly encourage everyone thinking of owner financing to search the internet for “ruthless default”, “strategic default” or other terms that come into use.  Along with a lot of junk, you will find well written articles on the pros/cons of this solution from both the lender and borrower side.  Each of you will have to decide how and if this will impact your owner financing decisions.

I thought this article describes current thinking very well.

This can be a real benefit in negotiations between buyer and seller as well as increasing the safety of the note.  Flexible terms may also help the buyer or seller without cost to the other party.  How does this work? Consider these examples.

The payment doesn’t have to stay the same.  An elderly seller may not want to commit to a thirty year loan.  The buyer may not be able to afford the payments if the loan term is shorter.  “Balloons are for Clowns.” is an old rule that says balloon payments are a bad idea.  However, if the payments have reasonable increases each year, or at preset intervals the payment can be affordable, yet pay off the loan in an acceptable time period.

Why don’t banks offer these options.  Banks want all their mortgages to be identical so they can bundle them up and resell them.  Doing loans with non-standard terms would me they have to hold the note themselves and most don’t want to do that.

The interest rate can also change.  Conventional loans with adjustable rates were popular.  However, with private notes the interest rate changes can be used for purposes other than protection from prime rate increases.  Have you noticed how car dealers will offer you a choice of zero percent interest on your car loan or a lower price if you pay interest.  That works with home loans too.

If you raise the sales price (loan amount) and lower the interest rate more of the monthly payment will go to principle and less to interest.  For the seller that means more capital gains type income and less interest income.  Depending on the sellers tax situation this can be significant.  For the  buyer it means they will have less interest to deduct but they may not need more deductions anyhow.  It all depends on the individual situation.

I have only touched the surface of what can be done with seller financing but it should give you an incentive to think creatively if you find yourself negotiating seller financing from either the buyer or the sellers side.

The appraisal came in for less than the loan balance! There are multiple repossessions in the neighborhood.

The is a perfect example of the ugly real estate market we have right now.  Everyone is going to loose in this situation so it is no wonder the note buyer has no interest in buying the note.

Implications?

The buyer has just thrown away their down payment money.  Consensus says it won’t come back for a long time, if ever.  Many people in this situation have found they can buy one of the repo houses in the same neighborhood for less money and/or smaller payments.  They may continue to make payments if they can and if the house isn’t to far under water.  However, the payment stream has to be considered VERY uncertain.

The note holder should consider themselves fortunate if the buyers continue to make payments and maintain the property. Since there were no loans on the property they can probably use the note as security for a loan equal to some percentage of the new, lower, appraised value of the house.  They would be liable for that loan if the buyer walks, but it would at least give them some money immediately.

The bottom feeding vultures are always around so if the note holder gets to a point where they MUST sell the note (or the house if they get it back) they may very well end up getting half price or less.

Most people don’t realize that losses on the sale of a personal residence are NOT tax deductable! This is no doubt a big surprise for many.  I don’t know if in this case the loss would be deductable or not.  In any case, deductions only help if you have income to offset.

The appraiser found the buyer was renovating both units, both were vacant, and there was no completion date scheduled.  That was the end of that deal.

This is one of those cases where the note holder probably didn’t have any idea of what was going on.  As long as the payments came in on time why should he worry?  The problem is this is no longer income property.  The payments will continue as long as the buyer can afford to make them.  The renovation will continue as long as the buyer can afford to buy supplies and/or hire or provide labor.

If the rental market drops the buyer may decide a profit is no longer possible and walk away.  If the buyer looses his job or some other event reduces his income, he may no longer be able to feed the property.

In our current economic situation, depending on the location of this property, the value of the property could have declined by more than 20% since the purchase.  Many places in the country have had property value declines greater than 20% which would mean the buyer is actually under water.

If the payments stop and the note buyer has to foreclose they will be getting a property with no income, which will take time and money to get back into shape.  No investor I have ever heard of looks forward to completing a rehab project long distance.  They are hard enough to manage when they are right in your own back yard.

What’s the note holder to do in this situation? It will come down to how badly & quickly he needs cash for his note.

If he can afford to wait a couple of years the buyer may get the renovation done and the property rented again.  Once there is an established post-renovation rental history the note may be marketable.

If the need for cash is more urgent the note holder may want to have a talk with the buyer and see if the buyer could pay him off with a heavy discount.  If the buyer has family or friends with money in low income CD’s or savings they might be willing to use some of it to buy the note at a discount.

It is also possible a local investor with rehab experience would be interested although a national note buyer is not.  A local is in a much better position to fix the problems if the buyer walks away or can’t/won’t complete the rehab.

It doesn’t take much to knock 5% off the value of a house.  If the buyers don’t take care of it, do maintenance as required, etc. the equity will quickly disappear.

Even worse in these economic times, the property may very well have gone down in value.  If a major employer in the community is cutting jobs or other bad things are going on the 5% equity will soon be gone.  The reports I am seeing indicate there are millions of people who owe more for their home then it is worth.

In many ways the buyers of this house have been “underwater” since the day they bought.  If they wanted to sell the commissions and transaction costs would be more then their 5% “equity”.

What can the seller (note holder) do?

• The note holder might be able to find a private investor or financial institution to lend against the note.  If the note holder is financially strong and has an established relationship with a local credit union for example.
• The note holder might be able to work with the buyer to get paid off early.  Chances are the buyer is not financially strong; that’s why they did an interest only loan.  Sometimes people have money coming from the settlement of a lawsuit or estate.  Sometimes they need a year or two to clean up their credit.  Sometimes they have relatives who will co-sign on a new loan.  This might be especially attractive if the note holder offers a significant discount for early payoff.

The cynic in me says the note holder better get ready to take the house back, renovate it, and figure out a more creative sales approach.

So, what’s a more creative approach?

One technique would be to create two notes.  The first position note of perhaps $50,000 would be an amortizing note with a market interest rate, that pays off quickly; five years perhaps.  This would have a lot of equity above it and could be sold easily for a small discount.  The second note would have very soft terms; small payments etc.  The payments would be set to increase after the first was paid off.

The buyer wouldn’t care because their payment on the two notes would be structured to be the same as what they pay now of the single note.  The seller (note holder) however would be in better shape because he would at least have something he could sell.

Could the seller (note holder) go back and renegotiate the deal?  I would think it might be worth a try if he really needs the money.

An offer was made to the seller (Person being paid on the original note) and accepted.

At that point the prospective note buyer ran a credit check on the buyers and discovered their credit was terrible.  Their FICO score was in the low 500’s and none of the investors who buy notes will touch a deal with such a low credit score.

I suspect this kind of situation will be more common in the months/years ahead because the economic downturn is changing previously good credit risks into bad risks.  Lets face it, if you loose your job and can’t find another one, your ability to make the mortgage payment goes away no matter what your intentions.

I would guess the note seller in this case didn’t know the buyer’s financial condition.  He had been getting his payments for fifteen years so why should there be a problem now.  Unfortunately, the same economic problems that are effecting the buyers are probably what motivated the note holder to try and sell the note.

Assuming the note holder needs the money, what can he do now?

• Sell part of the note.  If the note holder doesn’t need all of his money an investor might be willing to buy a “partial”.  For example, an investor might be willing to buy the next five years of payments for $50,000 (made up number).  A loan like that should be quite safe in the event of default.  If the buyer continues to make their payments the note would revert to the original note holder after the investor had received his five years of payments.
• Borrow against the note.  If the note holder has decent credit and/or other assets he may be able to borrow against the note.  In the even of default he would have to continue making payments on that loan, but at least he could get some money.
• It might be worthwhile for the note holder to talk to the buyer about other options.  Maybe the buyer has friends or family that would pay off the loan early in exchange for a large discount.  Maybe a family member would co-sign so the buyers could refinance.

There are always choices, but they require some thought and planning.  Keep in mind you need to start making these kinds of plans well in advance.  The actual transaction will require title insurance, a closing, and all the other details of a real estate sale.  If you wait until you absolutely have to have the money quickly you will pay a big price for your lack of planning.