Complications arise when home is underwater
If a couple is not married when they purchase a house, the possibility of a future split looms large, and they should agree before the purchase on how the house will be handled if it occurs. If they can’t agree on that, they should reconsider whether they want to live together.
If a couple is married when they purchase the house, the presumption is that they will remain together, and deciding on how they will divide the house if they split is the last thing they want to think about. Nonetheless, the issues that arise with a split are the same whether the split is anticipated beforehand or not. The difference is that agreement is much easier and less costly if done beforehand when the relationship is warm.
Selling the house is the way to a quick and clean break: The only issue is deciding how the proceeds are to be divided, although this can be quite contentious when it is not agreed upon beforehand. Unless the couple can agree to accept the judgment of a neutral third party, it will have to be delegated to lawyers to negotiate, at which points the costs begin to mount.
One approach a third party could use is to divide the net proceeds according to each party’s contribution to the equity in the house when it is sold.
Suppose, for example, that the couple paid $100,000 for a house, took a mortgage of $80,000, paid $20,000 down plus $3,000 in settlement costs, and sells it after five years when the loan balance is $74,000. Total contributions of the parties to equity in the house at the time of sale consist of $23,000 in cash at purchase, plus $6,000 in reducing the loan balance. If one party contributed 60 percent of the cash and paid 40 percent of the expenses, that party’s share of net proceeds would be [0.6(23,000) + 0.4(6,000)] divided by 29,000, or 56 percent.
When one party retains the house, it can get complicated: Very often one of the parties wants to remain in the house. In such case, the cleanest approach is to have the remaining party pay the departing party the latter’s share of the net property value. This requires that the remaining party have the cash needed for that purpose. The two parties must also agree on how their respective ownership shares are to be calculated, and how the house will be valued. Since the property is not being sold, its value must be based on an appraisal, which requires the parties to agree on who will select the appraiser, who will pay for it, and whether marketing costs will be deducted from the valuation.
A clean break also requires that the departing party be removed from any existing mortgage obligation. This means that the remaining party must have the income and credit required to refinance the mortgage in her own name.
When one party retains the house but cannot pay off the one who leaves: Usually, the party remaining in the house doesn’t have the money to pay off the party leaving the house. The more equity they have in the house, the more cash the resident party needs for that purpose. A home equity loan is not possible unless both parties become responsible, which is the last thing the departing party wants.
Taking the departing partner off the hook: In most cases that I encounter, the party leaving the house is less concerned with his claim to equity in the house than in obtaining relief from liability on the mortgage. Many departing parties believe erroneously that they are off the hook if the party remaining in the house agrees in writing to assume full responsibility for the mortgage. They overlook the fact that the lender is not a partner to their agreement. Departing partners remain liable for their mortgages unless the lender agrees to remove them.
Lenders have no incentive to remove one party from the mortgage. Some can be induced to do it if the partner remaining with the house has a perfect payment record and can document that they are solely responsible for the payments. But in the best situation this takes time, perhaps a year or longer.
The most equitable resolution: If I were drafting an agreement for a loved one, not knowing whether they were more likely to be the remaining or the departing party, it would grant the remaining party 14 months to make the settlement payment, and to remove the departing party from the mortgage. Otherwise, the house must be sold and the mortgage paid off.
Complications introduced by a declining market: If the house is worth less than the mortgage balance when the couple split, which is very possible if they purchased in 2005-2007 and split today, the options are grim. The house can’t be sold unless the parties pay the deficiency. If neither wants to remain in the house and make the payments, the alternative is foreclosure, which will destroy the credit of both parties. If one party wants to stay in the house and continue to make the payments, the party that leaves avoids foreclosure but will remain liable for the mortgage indefinitely.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.