|Ellen McGirt of MONEY Magazine talks about how to take care of your finances when a disaster strikes. (September 20)|
NEW YORK (CNN/Money) – Imagine it's July and you're behind on your mortgage payments, or you're making them, but just barely. You don't have adequate homeowner's insurance, and you've borrowed against the equity in your home.
Now fast forward to today. A hurricane has obliterated your house, your job and very likely the property values in your area. The few things left in tact, it seems, are your mortgage and your other debts.
What's a homeowner to do?
That's a question that will face an untold number of Katrina survivors in the coming months.
For now, mortgage companies are cutting all sorts of breaks. They are letting survivors defer payments, waiving late fees and not reporting delinquent accounts to the credit bureaus.
But at some point payment will come due.
There are 1.4 million single-family residences in the federally declared disaster areas in Louisiana, Mississippi and Alabama, according to data from First American Real Estate Solutions.
The National Association of Realtors (NAR) estimates that a minimum of 200,000 homes have been lost to Katrina, not including homes that are damaged but repairable.
Meanwhile, the Mortgage Bankers Association (MBA) estimates that there are 360,000 first mortgages in the affected areas. As of July, there were close to 70,000 prime and subprime mortgages that were delinquent by 30 days or more, according to Loan Performance, a subsidiary of First American.
And homeowners in the disaster areas had taken out at least 46,000 second mortgages before Katrina struck. Add to that the temptation in recent years to refinance first mortgages in a low-rate environment, and you find very few homeowners who kept all the equity in their homes, said Kirsten Foyles, a real estate attorney in North Carolina.
Some scenarios facing hard-up homeowners
In cases where homes have been destroyed, any insurance proceeds go first to paying off the mortgage, said Jay Brinkmann, MBA's vice president of research.
Those proceeds may not be enough to satisfy the homeowner's debt. Nor might a sale of the property.
In the immediate months following other devastating hurricanes, mortgage bankers were very lenient with homeowners, as they are being today, said Brad Botes, a bankruptcy attorney whose firm has offices in Florida, Mississippi, Alabama and Tennessee.
But after six to nine months, he said, the mortgage companies got more aggressive, threatening foreclosures.
Given the unprecedented scope of the Katrina disaster, there's no telling what mortgage bankers will do if faced with high numbers of distressed borrowers and abandoned properties. But it's a good bet they will be willing to negotiate deals with homeowners, Brinkmann and Foyles suggested.
The foreclosure process can take up to 18 months, and it is usually a lender's last, and least favorite, resort.
A foreclosure can be averted if a homeowner sells the house and pays off his loan. But if the sales price isn't sufficient to cover the homeowner's debt – very possible in the hardest hit areas -- the lender can sue the homeowner for the difference. Again, that's undesirable and unlikely, Brinkmann said.
Another option is for the lender to agree to a "short sale" – meaning the lender would forgive any remaining debt after a property sells.
Normally forgiven debt is treated as taxable income to the homeowner. But lawmakers have included a provision in a Katrina relief package that would treat forgiven debt --including mortgage and credit card debt -- as tax-free.
In the case of abandoned properties, where homeowners have left the state and can't satisfy their debts, it's possible mortgage companies will just have to write those properties off as losses, Brinkmann said.
Foyles thinks both lenders and homeowners might lose if they stick to traditional foreclosure and short-sale methods in Katrina cases. "One possible solution would be an arbitration-type system between the lenders, insurance companies and government agencies to expedite claims and remedy losses," she said.
Bankruptcy filings expected
Delinquent mortgage payments and home foreclosures can seriously hurt a homeowner's credit rating. So can bankruptcy.
Nevertheless, the multiple financial strains on some Katrina survivors will be great enough that bankruptcy attorneys expect the disaster to push some financially responsible families into bankruptcy.
That's why, along with consumer advocates, they have called on lawmakers to exempt Katrina survivors from a new and more stringent bankruptcy law going into effect Oct. 17.
They want Katrina survivors who need to file for bankruptcy to do so under the more lenient bankruptcy provisions currently on the books. The reason: it will be easier for debtors to file for Chapter 7 bankruptcy, which grants them what's called a "fresh start."
At present, three pieces of legislation have been introduced that, if approved, would exempt Katrina survivors from certain provisions of that new bankruptcy law.
Should anything pass – and it's not yet clear if anything will -- it's likely to be part of another Katrina relief package that lawmakers are working on, said Travis Plunkett, the legislative director of the Consumer Federation of America.
(See how provisions of the new bankruptcy law would affect debtors and why consumer advocates oppose them.)