What happens to loan from parents for now distressed property?

Q: My wife and I are in our late 60s, and two years ago we loaned my son and his wife $60,000 for a down payment on a home. They bought the home for about $400,000, and now it is worth about $350,000.

The interest rate on the loan is 5 percent with a full repayment of the loan this coming summer (it was a balloon loan). My son and his wife are divorcing, and my daughter-in-law will keep the house with their two children. She has a good job so she can handle the loan payments.

The problem is the balloon is due in about seven months and they can't refinance, as there is no equity in the home. If she sells the home, the proceeds of the sale won't be enough to pay us off. My son's name is still on the deed. What do recommend we do?

A: We're sorry that your son and his wife are getting divorce. However, even if they were not, you'd still have a problem on your hands. As a lender, you effectively have no collateral for the loan. Presumably, you documented the loan and have a promissory note signed by your son and daughter-in-law along with a mortgage filed against the home. That promissory note obligates your son and daughter-in-law to repay the money to you whether or not there is equity in the home.

Your choices will be to extend the term of the loan and continue to receive payments under the loan, to forgive the debt, or to demand payment on the loan when it comes due later this year. What you decide to do is only one part of the equation. What your son and daughter-in-law decide to do is the other side.

As part of the divorce proceedings, your daughter-in-law could become the sole owner of the home. However, the mortgage loans associated with the home would continue to be a part of the home and the obligations to repay that debt would still be both your son's and your daughter-in-laws' obligations. Depending on what assets they have, they could decide as part of the divorce to pay the loan off, but paying you off will depend on what assets they have and their desire to deal with your loan.

As a lender, you will have the right to decide what path to go when the loan comes due. However, if as part of the divorce they decide to refinance their first mortgage, put title of the home solely into your daughter-in-law's name, they will need your consent to either remove the loan from the title to the home or to keep the loan on title as long as the loan becomes subordinate to the new first loan on their property.

Unfortunately, we can't tell you what to do. You will need to sit down with them and determine what path each party wants to take, and then make a decision for yourself.

If you were a big box lender and they decided to sell the home, they would have to sell the home as a short sale. The first lender would get most of its loan paid off and you, as a second lender, would get a token amount or nothing.

Please let us know what you and they decide to do.
