What happens if you default on an investment-property loan?
Defaulting on your investment-property mortgage can be costly
- Defaulting can put you on the path to a foreclosure action.
- If you have a recourse loan, the lender can sue you to recover any collateral deficiency.
- An LLC ownership structure can offer some protection from personal liability if you default.
What happens if you default on your real estate investment’s mortgage? Going into default can ultimately lead to your investment property going into foreclosure, which can have disastrous ramifications for your credit.
What exactly is default, how can you avoid it, and — if your property is already in default — how can you get out of it?
Road to foreclosure
Going into default is the first step on the road to foreclosure.
A lender will issue a “declaration of default” when the borrower fails to make timely mortgage payments after a certain period of time — usually around 60 to 90 days.
Foreclosure is the process of the lender taking possession of the property from the borrower. Foreclosures are processed in the state court system, and foreclosure laws vary by state.
A foreclosure can have a disastrous and long-term effect on a borrower’s credit. A foreclosure resulting from a default stays on a homeowner’s credit report for 7 to10 years, and can lower a credit score by 85 to 160 points.
If the borrower fails to make the mortgage current, the lender can offer the property at a public auction. In some states, the lender may sue the borrower for whatever portion of the mortgage the proceeds of the auction failed to cover.
Recourse vs. non-recourse
There are two types of loans available to borrowers: Recourse loans and nonrecourse loans.
If you have a recourse loan, it means that you are personally responsible for paying whatever balance of the loan remains after the lender liquidates any assets serving as collateral for the loan. So, if your property goes into foreclosure and the lender sells it, but for less than what you still owe, they can sue you for the difference, known as a “deficiency.” If you have a nonrecourse loan, the lender won’t be able to sue you for the deficiency.
If the lender receives a deficiency judgment against you, they may be able to garnish your wages, freeze your bank accounts, or place a lien on your other properties.
Additionally, each state has its own laws governing when a lender can sue to make up a deficiency in the loan amount.
If you own investment properties in your own name, you will likely be personally responsible if the property goes into default.
That risk can be mitigated if you own the properties through a limited liability company, or LLC. If you default on the loan, only the LLC will be held liable, not you personally.
The exception is if the lender required you to personally sign as a guarantor on the loan, in which case you and the LLC would both be held responsible for the loan.
Getting out of default or foreclosure
What if your investment property is in default already? Can you get out of default before your property goes into foreclosure?
There are a variety of strategies to help you get out of default. These include the following:
- Negotiating a loan modification;
- Declaring bankruptcy;
- Pursuing a short sale; and
- Turning over the deed in lieu of foreclosure
If you’re already in foreclosure, government programs exist to help you. Two federal programs originally designed for the owners of primary residences going into foreclosure — the Home Affordable Modification Program (HAMP) and the Home Affordable Unemployment Program — have been changed to accommodate the owners of rental properties.
Ultimately, if your investment property is in default or at risk of going into default, your wisest course of action is to consult with a real estate attorney who can advise you on how to proceed.