If you’re not aware of what a Home Equity Line of Credit is, here’s a simple explanation.

If you purchase a home for $100,000 and the value increases to $150,000.00 you can borrow money against the value of your home. There are basically two ways to do this.

Cash Out Refinance:

That’s when you refinance the entire loan at a higher dollar amount than your original loan.  80% (typical refinance amount) of $150,000 is $120,000.  So, if you owe $80,000 on your original loan, (again, you purchased with a conventional in this example) then the old loan would be paid off, and you would receive the difference of $120,000 less $80,000 for a total cash out refinance of $40,000 and a total loan amount of $120,000.  Another way to look at this is that you’re digging yourself deeper into debt for a longer period of time.

Home Equity Line of Credit (HELOC):

This is when you present the value of your home to a lender who is willing to give you cash in exchange for a security interest in your home.  For example, your $150,000 home which only has a loan of $80,000 on it has $70,000 in equity which any lender would be happy to help you tap into for an annual interest rate.  If you do so, a 2nd lien will be placed against your home and you will have two payments.  The first payment will remain as it was, and the 2nd will become a revolving line of credit much like a credit card.

It is questionable whether or not the first loan could still be considered, or at least a portion of it could still be considered a purchase money loan.  (That’s a loan that was used to buy the house) and this is important when figuring out whether or not you can be handed a judgment if you default.  A HELOC, on the other hand, is simply a revolving ATM cash line of credit with a low interest rate and interest only payments.  Again, you’re still borrowing money from the equity in your home.

We all know what happens when we stop paying our 1st lender.  They typically exercise the right to sell your house at a Trustee Sale.  What is unclear to many is what happens when you stop paying your 2nd payment, but continue to pay the 1st.

Possible Outcomes

There are a few things that a lender on a HELOC may do to resolve past due payments.  While the note is secured by your property, if you don’t have any equity in your property, then they aren’t going to exercise their right to sell the home, because the 1st lender will receive all of the net proceeds from the sale, and the 2nd will simply be out of luck.

So, they could, but likely won’t file a Trustee Sale notice to sell the house out from under you.  Each lender is different in how they approach collecting bad debts.

Another solution would be to allow you to re-instate the loan by getting caught up.  There is a period of time that the lender will give you, which is defined by each lender, and usually never adhered to 100%, in which you can do this.  If you get caught up, plus all late fees, then it’s likely you can continue in good standing in the future.

If they grow tired of waiting for you to communicate with them to get caught up, and they recognize that there is no equity in your home, there will be a point at which they decide that it’s time to dump the bad debt.  They do this by charging it off.  This involves selling off the debt, most likely to an in-house collection company under their corporate umbrella, and then hiring an attorney to handle communications with the delinquent borrower.  When the file is sent to the attorney and charged off, you can basically kiss all chances of re-instating the loan good bye.  It’s at this point that you’ll start receiving scary letters from the attorney, and you’ll have only two options.

1.  The worst option, get sued, go to court, have a judge slap a judgment against you, have your wages garnisheed or your account levied, and be forced to pay back what you owe, with steep annual simple interest penalties, is possible.

2.  The better option is to settle for less than the amount owed, which is not always a guaranteed option.  In the Short Sale world, this is what we do in order to make the 1st and 2nd go away.  Sometimes even a 3rd lender is involved.  In the world of HELOCs where you’re not past due on the 1st, and the 2nd has threatened to sue you, your bargaining power increases dramatically…but only if you have money to settle.

About That Bargaining Power.

Money talks.  Think about this.  If I owe you $100.00 and I pay you $50.00, then I don’t pay you for a few years, it’s likely that there will be a point in time that you write it off or forget about it.  It’s at this point that I come to you and ask you if I can settle the remaining debt for $10.00.  You figure, heck, it’s the best I can get, so sure…I’ll do it.  That’s the risk you took in loaning me the $100.00.  The catch is that I have to have the $10.00 to pay you. Oh, and that you’ll probably never loan me money again, and have probably written me off as a trustworthy person.

So, in the case of a HELOC, your best method to avoid a law suit is to bring a settlement to the table.  Many lenders will be happy to accept ten, fifteen, even twenty cents on the dollar to satisfy the debt.

BEWARE!  Your settlement agreement with your lender when it comes to a HELOC must include a release of lien on your property as well as a full release from the remaining debt. Have an attorney look at your lender’s settlement offer, which should be in writing, always!

Consequences

Your credit is already damaged because you’re late on the payments anyway, so that’s no longer a concern.  You’ve probably already dealt with that part emotionally.  The one BIG consequence to debt settlement of this magnitude is that the forgiven debt will be looked at by the IRS as income.  Any time you settle debt for less than the amount owed, the difference is considered income.

To understand that better, think of it this way.  Your lender handed you $100,000.  You had $100,000 come “in” to your account.  You failed to pay it back.  They wrote off a portion, and the amount you didn’t pay back becomes recognized as income.

It’s going to be up to your CPA to determine whether or not income tax is owed on the amount forgiven.

The moral of the story?  Stop borrowing money.  Start saving.