Last Friday, on MomsMakingaMillion radio with Gina and Kat, the topic of deficiency judgments was discussed in the MoneyTips section of the show.  I know something about foreclosures and wondered if what was being discussed could be prevented and how.

In a previous article here, we looked at the possibility of walking away from your home. The obligation, we argued is one that involves two parties: lender and the borrower.  Every financial contract, we all know comes with obligations.  But exactly how those obligations are applied can vary from state to state.

Gina, who resides in Nevada, gave fair warning to the homeowners in her state about the pitfalls of owing money long after you have been foreclosed.  Called a deficiency judgment (the only states that have no right for the lender on the books are Massachusetts, Mississippi, West Virginia and Delaware), this action theoretically allows the lender to pursue you for the balance of the loan due after the house has been foreclosed, .  While on the surface, this seems like an additional blow to your already decimated financial world, but there are steps that must be taken and certain rules that protect you.

The lender cannot pursue a lien on any other home or property, or garnish wages during the process. This is usually the biggest concern to folks involved in the foreclosure process.  Before I discuss some of that process, it is important to note that your wages are not part of the loan agreement to buy the house. The house is the collateral and the bank is only obligated to get what collateral they have agreed to in return.  That doesn’t mean that they couldn’t go after you for the deficiency judgment though.

In order to go that route, the lender would have to take the homeowners back to court.  This is assuming you were obligated to go to court in the first place.  Some states have judicial foreclosure which requires you to have your fate decided by a judge.  In many states, the deficiency judgment can only come as a result of this process.

A non-judicial foreclosure is spelled out in your loan papers as a “power of sale” clause.  This describes how it works and how long the process takes.  Unfortunately, this is one of those important papers you gloss over when signing the reams of documents required at the title company.  Nevada has just such a law and it can be used to try and get you to pay for the balance of the loan.

Keep in mind that there are time tables that must be closely followed.  If the lenders does not, for whatever reason, adhere to those rules, the non-judicial judgment may be questioned.  In short, you will receive a certified letter explaining that you are in default and must, as they say in the loan business, cure the debt. But if you were able to do so, you probably wouldn’t be in this spot in the first place.

Before you get in that situation, attempt to work with the bank as much as possible.  In the current economy, the bank doesn’t want your house back.  They would just as soon see you in it.  You might be able to negotiate a forbearance, allowing you a couple of months to get your finances in line.

This has been a real sticking point for the Obama administration as banks have been reluctant to work with borrowers who are in trouble.  If you see no way out of your current situation and your finances do not look to be improving, file for Chapter 7 and rid yourself of your unsecured debt.  This will allow you to stay in the home and possibly realign your finances enough to keep paying the mortgage, underwater or not.

Once the process has begun and the timelines are being adhered to, there is little you can do. You signed the documents at closing and they are legally binding. Nevada also has the ability to accelerate the loan once you reach default, making payment in full the only option.  Once the house is sold (and there are rules surrounding this as well) the lender, at least in Gina’s state, has the right to come after you once three months has passed.

The question is: will they?  Not only will they need to hire local attorneys to file the lawsuit paperwork, they must also schedule a court appearance to get the judgment from the court.  That leaves the lender looking to the local jurisdiction to enforce the court order.  This is a long and costly process and may not be worth the effort of the bank to chase.  They may simply write down the loan and move on.

To understand the process the lender must go through, keep in mind that the lender borrows as well from the Federal Reserve.  The Federal Reserve requires lenders to put potential losses aside in a non-interest bearing account, tying up valuable, loan-able cash. This, and the perceived ability of the lender to get what they are looking to recover depend on whether you can even come up with the cash.

They will ask for a Net Worth Statement (be truthful) and determine whether the whole process is worth chasing at that point.  Dave Dinkel, author of “32 Ways to Quickly Stop Foreclosure” writes that some lenders “usually chooses not to get a deficiency judgment and instead report the loan deficiency amount on IRS Form 1099. The result to the homeowner is a “phantom income” requires him to pay income taxes on this amount.”  This can be a cost-efficient method for both parties. The same tax rules apply for capital gains that are taxed ($250,000 for single, $500,000 for couples) as they would for phantom income – which you never really received.

Mike Walsh at ForeclosureFish.com suggests that it doesn’t necessarily stop there. The bank will sell the judgment for pennies on the dollar at that point and the process begins again.  There are several things you can do if this happens.

Don’t hide or lie or otherwise play stupid.  They will, at each dodge, add their costs to their pursuit of you.  And these costs will be passed on to you.  Here’s how you might endure the process.

Assume that the collection agency bought the loan for pennies on the dollar.  Their attorneys have found you and made you aware that the balance is due in full.  Negotiate and be upfront about your ability to pay.  While they cannot usually garnish your wages (in some states) the rest of your money (bank accounts, etc.) are fair game and will be taken.  So talk to them.  Offer to pay about 10% of what is due and tell them that you can handle the payments at that level.

They may balk but in many instances, they will be swayed by your good faith effort.  Keep i mind that they will not go away.  You can’t run or hide.  Unlike banks and other lenders, they will not write you off the books.

So Gina was right about the process although it doesn’t happen the same way everywhere.  These are money obligations that cannot be dodged and should be carefully considered when you buy (co-signing also makes you liable) anything.

While you might be able to walk away, the shadow of that debt will stay with you even if you try to ignore it.  Instead, try to be as honest as possible with the lender, the courts and the collection agency.  In many instances, you will not be free of the obligation, but far-less than you might expect will paid out of pocket for a lesson you should have learned beforehand.

The upside to this process: the loan may have been securitized (bundled with countless others) and may be hard to untangle.  The downside: no home and damage credit.

Find out how your state treats foreclosure and your options prior to getting to that point.