So, what if you can’t pay your mortgage?

With housing frenzied and realtors erupting in many markets, it may seem an odd question. After all, only a tiny fraction of borrowers are three months behind in their payments. But every day more people walk into more debt. We now owe over a trillion in residential mortgages. Never before have so many people bought so much real estate with so little down. If the economy were to soften, rates rise or lots of jobs be lost, then many owners might wonder: why would I continue to pay a mortgage which is bigger than my condo’s worth?

Most homeowners have no idea what transpires when they can’t cough up the monthly. An unknown number (lots, I’ll bet) believe there’s a Canadian equivalent of jingle mail. That’s the sound an envelope full of house keys makes when you mail it back to the bank. Large numbers of Americans, their houses underwater and unable to service their borrowing, just moved out and sent the keys back, or left them on the kitchen counter after receiving foreclosure notices.

In reality, most US states (39 of them) are just like most Canadian provinces: you can’t walk.

Technically, there are ‘recourse’ and ‘non-recourse’ mortgages. Canada is a country where the former applies, which means once you sign up for a mortgage you will never be rid of it unless you pay it off over time or through the proceeds of a sale. Only Saskatchewan has non-recourse lending, where deadbeat borrowers can wiggle out of debt. Most Albertans think all mortgages there are the same, but not if you have an insured loan.

So, with a recourse mortgage, here’s the drill: you miss a few payments and the bank will send you a lawyer’s letter telling you to get current. The cost of that letter is often added to your debt. If you fail to heed, then you may receive notice of a foreclosure or a power of sale, depending where you live. If you still don’t pay, the lender has the right to kick you out, or just list the house for sale (after some legal stuff happens).

The property must be sold for ‘market value’ which means the bank can’t flog it for half price to some vulture. But if that sale does not raise enough money to pay the outstanding mortgage principal, plus arrears, penalties and legal costs, you’re personally liable for the difference. The lender can (and probably will) move to seize other assets you have (like your wedding savings account at the same bank), plus slap a garnishee on your wages. Just imagine how that will impact your career.

There’s no easy way out of this, except bankruptcy, which sucks. Your credit rate will turn to mush and you may be effectively shut out of many job opportunities as well (of course) as not being able to score another mortgage for several years.

Remember, it doesn’t matter if a mortgage is recourse or non-recourse, because the lender can still come along and seize the asset you financed (your house), and sell it. The only difference is that outside of Saskatchewan or Alberta (almost) defaulting on your home loans means the rest of your finances could also be destroyed. That will include your TFSAs, bank accounts, non-registered investment accounts and, in many cases, RRSPs.

It’s been argued that having recourse mortgages in Canada is a good thing because the fear of having a bank up your butt for years is enough to keep people paying their mortgages, and house prices stable. But this is patently untrue. In fact, when housing corrects we could find that our mortgage system actually made things worse.

Remember that the two US states which were devastated the most in the housing crash – Florida and Nevada – are both full-recourse jurisdictions. No jingle mail there. They have the same system as Canada, and yet house prices fell in certain areas by as much as 70%. Same with Ireland. Full-course there, too, but the country became a symbol of real estate destruction.

How come? A research paper done for the US central bank has a few hints. It found that when people are in financial distress and can’t pay their bills, it makes absolutely no difference what kind of mortgage they have. In other words, the knowledge that their lender might sue, and they can’t just walk, has little or no bearing upon their actions.

More significant is how lenders are affected. Just as CMHC insurance encourages bankers to take on dicey borrowers at low rates, so does the fact that these are recourse loans. The lenders know if the homeowner fails they can just seize the house and use the courts to get everything back. No risk. So why wouldn’t they loan money to anybody who asks for it, even if they show up with no savings, no credit history and not even a downpayment?

This makes the banks lending-horny even when everybody knows a bubble exists and will eventually pop. It’s this realization which led to calls in Ireland for a ban on Canadian-style recourse loans, because they encourage irresponsible lending.

Others think when TSHTF recourse loans make recessions more likely, and worse. That’s because homeowners facing a slump, and understanding all their other assets could be fair game, will curtail personal spending in order to avoid a default, and a suit. That’s how a housing correction could turn into a far bigger, job-sucking mess.

I wonder how many virginal condo buyers know about this?