Strategic Defaults: Making a Calculated Decision to Lose Your Home to Foreclosure
Mortgage foreclosure rates inched higher in the third quarter of 2011, but at the same time there was a decrease in the percentage of people who are behind on their mortgages. The data comes from the Mortgage Bankers Association’s National Delinquency Survey, and was released earlier this month.
Although many people go into foreclosure because they’re in financial distress, some homeowners actually choose foreclosure, even though they can afford their mortgage payments. The process is what’s known as a strategic default.
A strategic default occurs when a homeowner who can afford the mortgage payments decides to simply stop making them, forcing the lender to foreclose on the home. In most cases, people who pursue a strategic default have done the math and determined that it no longer makes financial sense to own the home.
According to the Chicago Booth Kellogg School Financial Trust Index, as of March 2011 about 30 percent of all foreclosures were the result of strategic defaults. This is a slight drop compared to the strategic default rate in December 2010.
Often the home in a strategic default is “under water,” meaning the mortgage balance is much larger than the value of the home. If the homeowner decides that housing prices
won’t increase enough to bring the home’s value back in line with the mortgage, then strategic default may be an option. Other homeowners may opt for a strategic default if they must move—perhaps because of a job relocation—there’s a glut of homes for sale and they think there’s little chance theirs will sell anytime soon.
“In deciding whether to default, homeowners [should] consider the economic consequences of default as opposed to performance,” says attorney David P. Leibowitzof LakeLaw in Waukegan, Ill. “If the cost of paying a mortgage on a home with no equity is greater than the cost of renting a similar property, there is no economic value to paying the mortgage payment. Moreover, if the homeowner believes that on default, he or she won’t be facing a deficiency judgment, the incentive to default and walk away is very strong.”
Many people who support the idea of strategic default point out that individual homeowners typically feel they have a moral obligation to pay off their mortgage.
In contrast, businesses take a less emotional approach to contracts. If a company signs a contract, then decides it’s no longer in the company’s best interests to honor the contract, it may make a strategic financial decision to break the contract (though it may cost them in the short run) or even file for bankruptcy in an effort to shed its debts. (American Airlines is a recent example of a business that’s chosen bankruptcy to give it a more competitive edge.)
Pros & Cons of Strategic Default
Before deciding to pursue a strategic default, you’ll want to weigh the pros and cons, while also talking to a real estate attorney to better understand the process and its ramifications. Among the items to consider:
Con: A strategic default will have a negative impact on your credit report and credit score. Foreclosures stay on your credit report for at least seven years and lower your credit score—often by 200 to 300 points. With a lower credit score, you may have trouble obtaining credit and you may pay higher interest rates if you do qualify for new credit.
Pro: A strategic default may free up money that you could put to a better use. Assuming you can replace your big monthly mortgage payment with a smaller mortgage or rent payment, you will have more discretionary income to save or spend elsewhere.
Con: You may have trouble finding new housing. It’s common for landlords and mortgage companies to review your credit report before deciding to rent a home to you or give you a mortgage. Any negative items have the potential to cause problems, but foreclosure in particular may make real estate companies nervous. Fannie Mae, which backs many residential real estate mortgages in the US, has gone so far as to say that anyone who strategically defaults on a mortgage will be ineligible for a Fannie Mae-backed mortgage for seven years.
Pro: When you decide to purse a strategic default, one of the first things you do is stop making mortgage payments. Foreclosures take time, which means you may continue to live in your home—without having to make mortgage payments—for a year. If you live in a state with a glut of foreclosures or if your lender has more foreclosures than it can handle, you may even get to stay in your home beyond a year.
Pro or Con: In some states, your lender can sue you to try to recoup some of its losses. This is legal in states including Ohio, Pennsylvania and Illinois. In other states, known as “non-recourse states,” the lender cannot sue you if you strategically default on a loan. Non-recourse states include Arizona, Florida and Texas. Still other states allow a lender to file just one lawsuit against a borrower, which means the lender may have to decide between filing for foreclosure or filing a lawsuit to recoup its losses. New York, Nevada and California are one-lawsuit states.
“I recommend that a homeowner base their decision on three factors,” says attorney Lisa R. Wilcox of Wilcox Law P.A. in St. Petersburg, Fla.
“First, whether they have a true hardship (such as financial, medical or divorce), because they may not qualify in certain instances. Second, they [need to] understand that there will be a negative effect on their credit from a strategic default. It may not be as bad as a bankruptcy or a foreclosure, but that it will have an effect that is still to be determined. Third, timing. If they are going to strategically default they need to do it now because after 2012 the Mortgage Debt Relief Act of 2007 expires. If [they wait until after the Act expires], the forgiven debt…could be viewed by the IRS as taxable income.”
Jennifer E. King co-authors the Lawyers.com blog.
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