There is a great deal of publicity currently about the epidemic of foreclosure sweeping the country. Everyone knows about it, but the details are not well understood. The purpose of this Legal Guide is to explain the "why" of foreclosure. What causes it?
As explained in What is Foreclosure, a mortgage loan is a contract between a current or future property owner and a lender. The lender will loan the money, and in return will take back the right to take the property in foreclosure as a remedy for default.
In the mortgage contract, there are many terms and obligations to which the borrower agrees. The most obvious is the obligation to make the payments provided for in the note until the loan is paid off. However, there are others. Other important terms are the obligation to keep the property insured, to pay property taxes, to keep the property in satisfactory condition, to pay condo or HOA dues timely if any, and what is called a due on sale clause, which requires the loan to be paid in full if conveyed to a third party, meaning that the mortgage loan cannot be kept in place if the property is transferred.
Violation of any of these terms gives the lender the right to accelerated the debt, meaning, to call the loan in, and if not paid, to commence foreclosure to pay itself off, or to get as close as possible if the property is worth less than what is owed.
Technically violation of any of the terms and obligations undertaken by the borrower in the mortgage documents can be a basis for foreclosure. Those which we see most often are failure to make the contractual payment, failure to keep the property insured, failure to pay property taxes.
Failure to make the contractual payment
All mortgage loans involve a payment obligation of some kind. Most consumer mortgages require monthly payments, on the same day each month, until the loan is paid off.
Types of mortgage loans:
- Fixed rate loan: The interest rate, and therefore the payment necessary to pay off the loan, remains constant for the entire term of the loan.
- Adjustable rate mortgages: The contractual interest rate is tied to some external index which fluctuates over time and with these kinds of loans, the payment fluctuates with the margin to which it is tied. Some are adjustable every year, some every six months, or every month. It is very commonplace for borrowers to have taken these kinds of mortgages, which initially had a low (or "teaser") rate, making the payment look very affordable. Then, as the interest rate adjusted, the payments often increase enormously, at times doubling or even tripling, becoming impossible to pay.
- Direct amortization mortgages: A part of every payment goes to reduce the mortgage debt, so that, at the end of the term, the loan is paid in full.
- Interest only: None of the payment goes to reduce the mortgage debt. Interest only loans are never paid off. They are structured so that, on a specific date in the future, the borrower must repay the entire principal in a lump sum. This is called a balloon payment. While relatively unusual, amortizing mortgages can also have a balloon payment feature.
- Negative amortization mortgages: These are the most problematic of all. The payments can be less than even the interest accruing on the debt. If this occurs, the excess interest is added to the loan balance, so the balance goes UP with every payment.
There was a time when almost all consumer home mortgage loans were escrowed. This involved adding to each payment 1/12 of the estimated amount to pay property tax and insurance bills as they came due. In these cases, the mortgage company would collect the escrow funds each month and then hold them to make the tax and insurance payment each year. As annual tax and insurance amounts fluctuate, the mortgage company is required by law to adjust the escrow portion of each monthly payment. If these items increase, then that portion of the payment increases proportionately. Failure to make this payment is a default in the terms of the mortgage contract.
The payment to the mortgage company of a non-escrowed loan is only the interest and principal due, with no portion set aside for taxes or insurance. However, when the bills arrive for these items, the borrower is still obligated under the terms of the mortgage contract to pay them. If the borrower has been having a bad year, or for whatever reason does not have the money to pay these items, nonpayment is a default in the terms of the mortgage contract.
There were many people tricked by unscrupulous lending practices during the "boom" period to close on loans believing that the payment they were quoted was an escrowed payment, and so all-inclusive when they were not. These people were horrified to learn eventually that they were obligated to pay taxes and insurance in addition to the mortgage payment. Often this made the mortgage terms prohibitive, and so people were unable to pay both. If the borrower failed to pay, the mortgage company would step in and pay them. However, normally the mortgage company does not pay YOUR insurance premium, it waits until the policy is cancelled and then purchases force-placed insurance. This is also called lenders' single interest insurance.
Mortgage contracts allow the mortgage company to purchase insurance to protect its collateral from loss (i.e. fire, hurricane, tornado, flood) if the borrower does not provide the required insurance. The way this normally occurs is that the mortgage company, for reasons beyond the scope of this guide, purchases forced placed insurance at a rate which is often MUCH higher than the original premium. The mortgage company then adds this huge additional charge to the payment it expects the borrower to make to reimburse it. Failure to make the payment is default in the terms of the mortgage contract. To add insult to injury, this overpriced insurance does not even cover the borrowers' household contents as their own insurance did, only the structures.
Advances for payment of taxes
Mortgage contracts allow the mortgage company to pay property taxes to protect its collateral if the borrower does not pay them. In most states, unpaid property taxes can result in a tax sale which under certain circumstances can divest the mortgage from the property. Therefore, mortgage companies are likely to pay unpaid property tax, and then to add the amount they laid out as an advance to the next twelve mortgage payments to recoup it. Failure to make the payment is default in the terms of the mortgage contract.
Failure to make these payments for whatever reason, whether due to a loss of a job, an increase in an adjustable rate, addition of force-placed premium, are all considered "monetary defaults" and normally lead to foreclosure. Other kinds of defaults, such as failure to maintain the property in adequate condition, conveyance of the property to a third party, etc. are "non-monetary defaults" and are much less likely to result in foreclosure.