Bail Me Out!

Like many homeowners, the Petersons find themselves in a predicament. They purchased a home in 2007 for $450,000. They like the home and the neighborhood. Both Mr & Mrs Peterson have stable employment and can afford the home. But some of their neighbors are not so fortunate.

There have been a few foreclosures and short sales on their block. In fact the home on the corner had an open house last weekend. It's a short sale for a larger home on a nice size lot. The Peterson's always liked the exterior of the home, so they decided to walk down the block and take a peak inside.

They liked what they saw. Not only was it a larger house, but it had nicer upgrades: granite countertops, stainless steel appliances, wood floors, and beautiful landscaping in the back yard. This seemed much nicer than the Petersons' home. Mrs Peterson picked up the flyer and her eyes widened as she read the list price, $325,000! If this house was going to sell for $325,000, then what would their more modest home sell for? $250,000, or maybe less. Mr Peterson did some quick math in his head. They were probably around $150,000 upside down. He thought they might be slightly upside down, but nothing this severe. The Petersons' hearts sank.

The agent that was holding the open house introduced herself to the shell-shocked couple. After some quick pleasantries, she got the story out of the Petersons. It doesn't matter whose idea it was, but after 30 minutes the three of them came up with a plan.

The Petersons would purchase the house on the corner which they love. They would do an FHA loan with minimal down (3.5%). They would put their current home up for rent, and with their income they have no problem qualifying with both payments. But here's the kicker, in reality after closing on the new home, they will end up listing their current home as a short sale.

The plan makes perfect financial sense for the Petersons. They can get a bigger, nicer home with a smaller mortgage and lower monthly payment. And they get out from underneath a mountain of debt on their current home. This should be perfectly okay, right?

Wrong. This is a common strategy which has a name, "buy & bail." Mortgage lenders quickly caught on to this in recently years. A prudent underwriter for a mortgage company would deny the Petersons' application for the FHA loan on the new home. The reason is that they are likely going to default on their current mortgage. Why should the mortgage company care about the old loan?

The Petersons are going to pay the new loan as agreed. But most loans have a government guaranty or backing of some kind (FHA, Fannie Mae, Freddie Mac, VA, FDIC, etc). Therefore the industry is sensitive to any mortgage being defaulted, even for other mortgage companies. One should also be aware of their potential tax and deficiency liability will be when selling a home as a short sale or going into foreclosure. Consulting an attorney is recommended.