What Is a Distressed Mortgage?

When a bank or other financial institution lends someone money, the borrower agrees to specific repayment terms for repaying their debt. That generally means making monthly payments to pay off the principal balance as well as interest accrued on the loan. There are times when a borrower can’t make their regular payments, though. If a person is having trouble meeting their loan repayment obligations, they are considered a “distressed” borrower.

The concept of a distressed borrower can be applied to almost all loans, including a mortgage loan. When a person takes out a mortgage but then has trouble paying it back their loan will be referred to as a distressed mortgage. A distressed mortgage is often a precursor to a foreclosure, but it doesn’t have to be. If you’re a homeowner dealing with a distressed mortgage, it’s important for you to understand what options are available to remedy the situation and avoid a foreclosure.

What is a distressed mortgage?

A distressed mortgage occurs when a borrower is unable to repay their debt, but it doesn’t necessarily mean the homeowner has been forced to sell their property back to their lender — or at least not yet, anyway. A distressed debt may be under bankruptcy protection or the lender could believe the borrower is moving toward default. If you have a distressed mortgage, you may have missed at least one or more monthly payments and are beginning to receive notifications from your lender that your payments are either overdue or insufficient.

A mortgage can become “distressed” for a variety of reasons. Some mortgages become distressed simply because the borrower didn’t understand the terms of the loan agreement. The important thing to note is that you do have options if you have a distressed mortgage, and the actions you take could get you back in good standing with your lender.

What is a distressed property?

A distressed property is slightly different than a distressed mortgage. The term typically refers to property listings that are already in foreclosure and are being sold by the original lender. It could also refer to a home being sold by a homeowner whose mortgage debt is larger than the market price they can get for their home — what is known as a “short sale.”

However, homeowners will rarely refer to the homes that they’ve lost to foreclosure as “distressed properties.” In most cases, the term is used by real estate investors.

How to handle a distressed mortgage

Just because you’re facing a distressed mortgage doesn’t mean you’re going to lose your home.

Benie Khan, Chief Executive officer and Operations Manager of Federal Home Loan Centers, has some very specific advice for homeowners who are facing a distressed mortgage.

“Don’t panic. There are a few ways that someone in a distressed mortgage can ease their financial burden a bit,” Khan said.

Your first step should be to contact your lender.

“The borrower can call their current mortgage holder and ask for a loan modification due to some type of financial hardship,” Khan said. “This lets them change the terms of the mortgage to help keep up with payments. It can involve reducing the interest rate for a short period, extending the length of the repayment time, or changing to a different type of loan. The big upside here is that they get to stay in their home.”

Many states also offer assistance to distressed homeowners. For example, the Massachusetts State website has an entire webpage dedicated to resources for distressed homeowners. The U.S. Department of Housing and Urban Development also offers counseling services for avoiding foreclosure.

You may also be able to refinance a distressed mortgage on your own, especially if you’ve built up equity in your home. As a last resort, you could declare bankruptcy if you qualify. This could delay foreclosure.

Distressed mortgages and foreclosures

A distressed mortgage is often a precursor to foreclosure, but what is foreclosure?

When a bank provides a homebuyer with a mortgage, the homebuyer owns their property, but they are putting that property up as collateral for the mortgage loan itself. When the borrower fails to repay their debt, their mortgage goes into distress. If they don’t work with the bank to get back into good standing, the bank may seize the collateral used to secure the loan (i.e., the home) to make up for their shortfall. This is how homes are “repossessed” by banks.

Once the bank owns the property, they will typically try to sell it to make up for their losses.

Selling a distressed mortgage

Working with your mortgage provider is always your best course of action, as they may be able to help you postpone your payments or even refinance your mortgage.

“If these are not options and you need to sell your house, you may be able to sell it subject to the existing mortgage, especially if there is little equity in the home. In that instance, a buyer would purchase the house and take over payments, thus saving your credit by preventing a foreclosure,” Melanie Hartmann, owner of Creo Home Buyers, said.

You have more options if you’ve built up some equity in your home, and you may be able to cut your losses more substantially.

“If there is sufficient equity in the home, listing it with a realtor is also an option,” Hartmann said. “Or, you may wish to sell your house directly to a real estate investor so that you wouldn’t be asked to make any repairs.”

Khan recommends selling the home if working with the lender isn’t an option.

“In a lot of cases, the best option is to sell the home. If they have equity, then they can cash out and start over with lower monthly costs. If not, then they can short sell the home. If the lender approves the sale, it doesn’t just reduce the borrower’s debt obligation — it removes it completely,” Khan said.

You may be able to purchase a new home after a few years if your financial situation improves or you qualify for a government-backed mortgage. “With a short sale, you can purchase a home again after two to three years if you go through a government-backed program,” Khan said. “The FHA has a three-year waiting period after short sales; for the VA the waiting period is two years.”

Purchasing a distressed property

If you’re a real estate investor and you’re familiar with the business, purchasing a distressed property may be a good investment opportunity. These properties are typically less expensive than other options in the area, which means you can sell them for a profit if home prices go up or if you invest in improvements.

There are some downsides you should be aware of if you’re a homebuyer considering a distressed property. Distressed properties typically come with a lot of paperwork, so it may take much longer for you to be able to move into your new home.

There are also multiple reasons a home could be foreclosed upon. Any existing problems with the home and the title will become yours if you buy it “as-is” from the bank. A foreclosed home that hasn’t been maintained will require more investments to get it up to livable standards, which could impact the amount you save from the purchase in the first place.

The bottom line

If you’re facing a distressed mortgage, don’t panic. Get in touch with your lender and discuss your options for repayment. You can also see if you qualify for government resources. As a last resort, you could file for bankruptcy to delay a foreclosure.

If you’re a real estate investor, a distressed property might be a good investment, but only if you know how to turn a profit. If you’re looking for a home to live in, you probably shouldn’t buy a distressed property unless you’re prepared to deal with the paperwork, repairs and other risks.