John and Suzie Smith purchased their home is August of 2005. They recognized this as an opportunity to become homeowners, but were concerned their ability to make the payments once their adjustable rate mortgage (ARM) reset. It was easy enough to make the payments during the loan’s teaser period, but with the rate potentially doubling at its end, they discussed their options with their loan officer. The loan officer responded that in two years they would have more than 20% equity in the property and could refinance the first loan into one with a fixed interest rate and use excess proceeds to pay off the second loan. This all made sense given the rosy picture the loan officer painted.

Fast forward 24 months and the Smiths now face the daunting realities associated with the rapid decline in real estate prices coupled with tightening credit. Instead of the rosy picture that was painted two years ago when they made their decision to become first time homebuyers, they're facing the prospect of increased payments of approximately $900 per month as their first loan’s’ interest rate on a home that today is worth less than the amounts owed on their first and second loan. The term often used in the industry when describing the home as a financial asset is that it is “underwater.” That is to say when you compare the home’s fair market value to the secured liens, the net result is that it doesn’t balance out as an asset at all, but a liability.

Few would doubt that we as humans tend to avoid unpleasant situations. We hold out hope that a rich uncle or that recently purchased lottery ticket will resolve our financial difficulties. Mindful of that lesson we learned in grammar school about “ignoring the problem won’t make it go away,” John and Suzie need to adopt a business-like approach to their pending financial disaster. Key to situations like this is recognizing that if they continue down their current path, in a number of months after repeating the practice of robbing Peter to pay Paul, they will reach a point where it will be impossible to make their mortgage payments.

Before reaching that point, a fair question to ask is, “does it make sense to continue to make monthly mortgage payments if the reality of the situation is they will ultimately not have the financial resources to make their payments?” The answer should not come quickly. Its importance justifies steps that involve both investigation and learning. The goal of this series of articles is to provide readers with a roadmap that will assist them in reaching an informed decision as to the course of action they take. To reach that goal we will map out strategies that result from playing the “what-if” game.² This method provides a useful approach for identifying options that will guide borrowers towards the development of a solution to their unique financial problems.

In the next segment of this article, we begin the journey by utilizing simple accounting principles to ascertain when homeowners reach key milestones in their decision making process. Along this path we will discuss differing foreclosure processes and the application of both Federal law and the laws of the state where the property is located. We will also develop an understanding of what to expect from your lenders (who are probably better characterized in John and Suzie’s situation as their partners).

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