Dying with a mortgage: What happens to your home?

Elderly man and younger woman holding mortgage

Once upon a time, perhaps not so long ago, Americans were pretty sure they'd be free of most debt by the time they retired — at least free of the pesky mortgage that'd been hanging around for decades.

That fairy tale pretty much went poof along with the housing bubble.

And if recent trends continue, ever more of us will carry our home loans into retirement — or be forced to take on new mortgage debt by tapping our home equity just to live.

The percentage of homeowners age 65 and older holding mortgages increased from 22% to 30% between 2001 and 2011, while the rate of homeownership remained constant at about 80%, according to a May 2014 analysis of data by the Consumer Financial Protection Bureau's Office for Older Americans.

Those age 75 and older took the biggest hit, seeing their mortgage debt more than double, from 8.4% to 21.2%, during that time.

On top of that, those over age 65 are holding higher balances on their loans. Between 2001 and 2011, the median amount increased 82%, from about $43,400 to $79,000.

Percentage of older Americans with a mortgage

So what happens when the property — and the debt — land in the laps of heirs?

The simple answer is that the mortgage comes with the house, says Stuart F. Ebby, a lawyer and real estate expert with the Philadelphia firm of Hangley Aronchick Segal Pudlin & Schiller.

But nothing is ever simple, right?

So here are five scenarios that could happen if you hold a home loan when you die.

In each of these instances, Frank Donnelly, chairman of the Mortgage Bankers Association of Metropolitan Washington, D.C., says heirs should contact the lender soon after a death to discuss their options.

While deciding what to do, it's important to keep the loan current, Donnelly says.

"You don't want it to go into foreclosure."

Most mortgages also require that the home be kept in reasonable repair, Donnelly says, so taxes and insurance should be paid up.

Scenario 1. Your heirs take over your loan.

In most instances, federal law allows for the transfer of the loan to a relative or other heir when you die.

Although most home loans contain a due-on-sale or acceleration clause that allows a lender to demand immediate and full payment upon transfer or sale of the home, transfers due to death are exempt.

This means your heirs would take on your home loan with the same interest rate and payment you have.

"It's just as though it were handed to you by a deed," though you may have to follow legal formalities, such as filing a will or letters of administration in probate court, says Ebby, who is also a lecturer in the University of Pennsylvania Law School.

Scenario 2. Your heirs refinance the home loan.

If heirs want to keep a home, Ebby says, in most cases they would simply refinance the loan. This is especially true if they can get a lower interest rate or reduced monthly payments.

If your heirs can't qualify for a new loan but can afford to make monthly payments, they can always keep the original mortgage.

Scenario 3. Your heirs get the property free and clear.

If your relatives are lucky, your estate may have enough funds to simply pay off the loan. In this case, you'll have to direct in your will that other assets in the estate be sold to retire the mortgage.

If you took out a mortgage protection insurance policy, that would automatically pay off any balance.

But should an older homeowner take out an insurance policy specifically for that possibility?

"The first thing you have to ask yourself is, does this make sense?" says Ebby, noting that insurance gets pricier the older you get. "And then you have to look at the surrounding circumstances."

If your heirs want to keep the property and can afford it, why bother with insurance? But if your heirs would be strapped, a life insurance policy would solve the problem.

"Usually," Ebby adds, "the cost of the policy isn't justified."

Scenario 4. Your heirs can't afford the monthly payments.

In this case, they can sell the home or, in the most extreme case, walk away.

In instances where the loan is underwater, walking away might be the wisest move.

"They can just give it to the lender," Ebby says. "And if it's really underwater, and it looks like it's going to stay underwater, it makes sense to walk away."

Otherwise — say, if there's a sentimental attachment to the home and heirs want to keep it — "then you have to try to get together with the lender and see if you can work something out," Ebby says.

In some instances, a lender might forgive some of the loan balance, Donnelly says.

If you have to sell a home that's worth less than what's owed, the lender could agree to a short sale in which the estate would not be liable for any deficiency.

In case of a short sale, the estate would be off the hook for any loss. In a foreclosure, on the other hand, the lender could seek to recoup losses from the estate.

"They normally don't do that because there's not enough there," Ebby says. "What's the point of going against the estate unless you can collect? And if the estate was in such poor condition that you foreclosed, what's the chance you would collect the deficiency?"

Scenario 5. You took out a reverse mortgage prior to your death.

This is another matter entirely. A reverse mortgage is a lien on the home. If there is no co-borrower — or the co-borrower is also dead or no longer living in the home — the loan comes due when the borrower dies.

The heirs will only inherit the home itself if the reverse mortgage balance can be paid off without selling the property.

To accomplish that, your heirs would have to pay off the balance with cash from the estate or another source, or take out a new loan.

The more likely outcome is that your heirs will inherit whatever equity is left after the home is sold and the lender repaid.