Most people understand what happens when a bank or lender forecloses on a home: the homeowner (borrower) essentially stops paying the mortgage and the lender has the opportunity to take back and then sell the home to someone else through the process of foreclosure. But high foreclosure rates are just one of the problems facing the housing industry. Another problem for both banks as well as homeowners is the large amount of home equity loans and home equity lines of credit that are also being defaulted on as home values drop and the job market stagnates.

Avoiding Foreclosure

First, some good news. If you have a mortgage as well as a home equity loan and you are able to only afford one, you may still be able to avoid foreclosure by choosing the right loan to pay off. First, we need to look at each type of loan and what it really is.

A mortgage is a loan from a bank which allows you to buy a house, but there’s more to it than that. Essentially, the bank buys the house from a seller and then holds the house for you. Each month you pay the bank a portion of the money plus a little interest (which is how the bank makes a profit). In return for this interest you are allowed to live in the house. Your mortgage loan is, essentially, a secured loan against a house. This means that if you stop paying the loan then the bank has the right to take back your home and sell it to someone else. Your home is essentially the collateral on your mortgage.

A home equity loan starts out in a similar way: the bank loans you money in return for a portion of the value of your home. So if your home is worth $200,000 and you only owe the bank $100,000 then you essentially have $100,000 of “stored value” or equity in your home. A bank may then offer you $50,000 cash as a home equity loan, knowing that if you default on the loan then they may still be able to sell your home and get their $50,000 back. Again, this is essentially a secured loan against the rising market value of your house. You can read an expanded explanation of secure vs unsecured loans online.

But what if your home’s value drops back down to $120,000 instead of $200,000? That essentially means that you no longer have the equity in your home that you once had. Your “secured” home equity loan becomes an “unsecured” loan because the equity that once served as collateral as all but disappeared.

Now that you see what is happening with foreclosures and home equity loans, let’s make some intelligent decisions. If you are faced with the prospect of only being able to pay your mortgage or your home equity loan (which is usually, but not always, much less than your mortgage) then you should probably choose to pay your mortgage on time. The size of the loan makes a big difference in this case, but it is also generally more difficult for a bank or lender to fight a homeowner that stops paying a home equity loan when the equity is gone. Banks rarely are able to actually foreclose on a home for an unpaid home equity loan simply because another bank often owns the mortgage.

When someone defaults on a home equity loan the bank generally has two options. The bank can modify your loan or, in rare cases, actually forgive it. More likely, though, the bank can sue you in court just as they might if you had taken out an unsecured loan and then defaulted on it. This is a time-consuming and expensive process for a bank and, in some cases, is simply not worth it. If they do file a successful lawsuit against you then you may indeed be liable for paying back the home equity loan through garnished wages or through a modified payment plan.

Home Equity Loans After Foreclosure

After your home is foreclosed upon there is still the problem of having an open home equity loan. Once the bank takes your home it has the opportunity to sell it to another buyer. If the sale of the home generates enough money to pay of both the mortgage and the home equity loan then you may be off the hook for any debt.

In today’s housing market, though, more and more homes are underwater and selling for much less than the amount of money owed on them. Again, this means that your secured home equity loan may, in essence, turn into an unsecured personal loan. You could very well be liable to pay back that money and, in many states, you could be sued. That being said, some states do have laws which don’t allow lenders to come after you if you used that home equity loan money to actually purchase the home. The most common type of home loan that allows you to spend you home equity loan on the purchase of a home is called an 80/20 loan and it allows you take out one loan for 80% of the value of the home and a second loan (often lumped together with the first) for the additional 20% value of the home based on the equity value of the house. These types of loans are rarely offered due to the limited amount of equity available on most homes that are bought and sold today.

The amount of many home equity loans is so substantial that they should almost always be factored into the decision when deciding if you should walk around from your home. Even if you walk away from your home and your house is foreclosed on, the amount of money you owe through a home equity loan or open home equity line of credit could be staggering.