A strategic default, is the act of walking away from an underwater mortgage not out of necessity, but because it is in the homeowners best financial interest.
First American CoreLogic, a real-estate information company, recently did a study that suggests when a home falls below 75% of the amount owed on the mortgage, the homeowner begins to think about walking away, even if he or she can pay the mortgage.
What’s Driving This Trend
What’s driving this phenomenon, what are the consequences of choosing this route, and what about the moral issue of leaving that debt for the banks to deal with?
Driving this phenomenon is the rising number of households that are deeply underwater, owing much more than the current value of their home. First American estimates that 4.5 million U.S. households have crossed that critical threshold where their homes value has fallen below 75% of the amount owned on the mortgage, and that an astounding 2.2 million of these households are at least 50% underwater.
This problem is largely concentrated in negative-equity markets that most severely experienced the bubble. These markets witnessed dramatic increases in housing prices during the boom based largely on artificial demand created by speculators and investors, however, prices have since plummet by as much as 20-50%. These markets include states such as; Arizona, California, Florida and Nevada. In California last year, the number of strategic defaults was 68 times higher than it was in 2005, Florida, 46 times higher. In most other parts of the country the number of strategic defaults were about 9 times higher than in 2005.
Moral Issues – Just a Business Decision
Most homeowners, or homeowners as a group, don't walk away¦ that is they don't strategically default. Yet the fact is millions of Americans who are underwater, would in fact be financially better off if they did walk away, just like Morgan Stanley recently walked away from five properties in San Francisco, five buildings which were underwater. Morgan Stanley just gave the properties back to the bank. Homeowners typically from doing so because of anticipatory shame and guilt, and because of an exaggerative fear about the consequences of waking away from a mortgage.
These emotions of fear and shame and guilt are cultivated by the government, by the financial industry and, to some extent, the media. And they do this by cultivating a double standard, a standard in which Americans, average Americans, are told to have a moral obligation to pay their mortgage and to meet their financial obligations, whereas corporations freely and frequently default when it's in their financial best interest to do so.
And, in fact, these groups would be obligated to protect the interest of their shareholders and walk away from an underwater mortgage if it was a financially wise decision. The ongoing argument is that this norm asymmetry, the difference in norms between average Americans and banks, leads to distributional inequalities whereby average Americans are bearing a disproportionate burden from the housing collapse.
If you divorce the decision from guilt and shame and make it purely a financial one you would consider the current rates of appreciation in your local market, the anticipate future rates of appreciation and would then consider how long it will take to break even on your investment and return to profitability. You would also consider the cost of renting for 2-3 years while your work on rebuilding your credit, or the tremendous opportunities that exist for buyers in the current housing market if you are somehow able to immediately purchase another home.
What homeowners need to understand is that a contract is not a moral document, it's a legal document. And the law does not provide for punitive damages for breach of a contract because it's not considered to be a moral wrong.
In fact, the law encourages the efficient breach of contract¦ meaning people should default on a contract when it is in their economic interest to do so. And because sophisticated parties understand this, they generally decide in advance for the consequences for a default on a contract or breach of a contract. In the case of a mortgage contract, the bank is the sophisticated party, and the bank puts in the penalty. That penalty is if you default, then the bank gets the house back and that's actually the agreement. And so, a homeowner who lets go of their house and gives it back to the bank is honoring the contract and is, in fact, doing nothing immoral. The contract provides the option for default and in fact, in a non-recourse state, the bank cannot come after an individual for deficiency judgment and their only recourse is to take back the property. For those states that are recourse states, the right to pursue homeowners for a deficiency judgment can in fact be waived as part of the short sale negotiations.
The banks consider this risk of default every time a mortgage application is taken, and they factor this risk into your loan and the rate they charge you for that loan. As such, we tell people you have a contract, the contract gives you a right to walk away and you paid for that right to walk away by paying more money at closing.
Consequences of Walking Away
Walking away isn’t risk-free and while we wouldn’t advise anyone to strategically default, it is an option you may want to consider if you’re stuck in a home with a huge loss that you don’t expect to ever recover. That said, homeowners should not simply walk away and rather should first speak with a local Realtor who specializes in short sales and determine if this is an option they might qualify for. Do not just speak to any real estate agent as while many agents are not claiming the title of Short Sale Specialist and Certified Distressed Property Expert, most of these agents have only completed course work on this topic and have never actually successfully completed a short sale transaction. Rather, seek out a specialist, that is a Realtor with significant experience who has successfully completed a number of these transactions and can provide evidence of this.
Credit score implications
- Most mortgage lenders won't lend to people who have had a foreclosure within the last 5 years; so if you do a strategic default plan on renting for 5 years. If you convince the bank to do a short sale, this is reduced to 2 years.
- While you may be able to get a mortgage in 4 years, the foreclosure stays on your credit report for 7 years. Short sales are reported as foreclosures, and rather are reported as settled or paid. Interestingly, it's not the foreclosure or short sale that does the most damage to your credit report ” it's all the late payments you rack up as you move toward foreclosure or a short sale.
- Fortunately, those late payments will be off your credit report in 2 years.
- Depending on whether a loan is a "recourse" or "non-recourse" the implications will vary. Non-recourse loans are exactly that, in the event of default the bank can take the collateral for the loan (the home) but has no other recourse against the borrower if there is a deficiency. With recourse loans the homeowner may be held personally liable to the extent that the outstanding debt exceeds the proceeds realized from the sale of the collateral. The outstanding debt will be adjusted to include any additional interest, fees and penalties incurred in the time leading up to the foreclosure sale. It is entirely up to the lender to decide if, and who they pursue for deficiencies, however, if the borrower has little assets to speak of the bank is not likely to waste their time and money throwing good money after bad. Retirement assets are exempt so long as they are in the appropriate fund or account. That said, borrower can not make contributions to those retirement accounts for the intended purpose of predefault maneuvering *** If you convince the bank to do a short sale part of the negotiations will include insisting that they agree to accept the sales proceeds as payment in full and not to pursue you for a deficiency. ***
- If you have a Home Equity Line of Credit (HELOC) or other non-purchase money mortgage ” this is recourse debt and the bank can come after your wages or other assets if you default on the loan.
- If you default on a recourse loan, the bank will: 1) foreclose on the property; 2) determine if it is in the banks interest to sue the borrower in court for a deficiency and if so do so.
- If you decide to do a strategic default, you'll have approximately 12 months from when you stop paying until the home is foreclosed. But the only time guarantee is that the bank is required to notify you 91 days in advance of the trustee sale (the date the home will actually be foreclosed).
- There is a forgiveness of debt tax but it doesn't apply as long as you've lived in your home for at least 2 of the last 5 years and the mortgage was used entirely as purchase money” to buy the house. The Mortgage Debt Relief Act also offers protection.
- There is an additional form you'll have to submit to the IRS. Talk to your accountant.
- If you make the decision to do a strategic default you should be sure that you're comfortable with foreclosure as a possible end result. That said, there are some other options you could pursue with the lender.
- One alternative to foreclosure is a short sale. You sell your home as you normally would, but the bank has to agree to the purchase price ” which will be some amount less than what you owe on the home. The bank takes a loss on the difference between what you owe and the proceeds of the sale.
- A short sale will still be a negative mark on your credit, but not as negative as a foreclosure.
- In some cases, you could negotiate with the bank not to report the late payments (those payments you miss between the time you default on the loan and when the short sale goes through) to the credit bureaus.
- Another option is to negotiate down your mortgage principle. If you've decided already that you're willing to accept a foreclosure, if that's the end result, you could call the bank and ask them to reduce the principle you owe on your mortgage to the market value (or close to). If you no longer have negative equity (or as much negative equity), that should eliminate the reason you decided to do a strategic default in the first place.
I have to say that I am not an attorney and none of the information I've presented here should be construed as legal advice. If you have questions about foreclosure or strategic defaults or are thinking about defaulting on your mortgage, consult with a legal professional.
Other factors to consider
As mentioned, the period for eligibility of a future loan differ greatly between a homeowner who loses a home to foreclosure and a homeowner who successfully negotiates and closes a short sale.
Effective May 21, 2008 the homeowner of a primary residence who loses a home to foreclosure is ineligible for a Fannie Mae backed mortgage for a period of 5 years. With a successfully negotiated and closed short sale a homeowner will be eligible for a Fannie Mae backed mortgage after only 2 years. In a non-primary residence an investor who allows a property to go to foreclosure is ineligible for a Fannie Mae backed investment mortgage for a period of 7 years. In a successfully negotiated and closed short sale an investor will be eligible for a Fannie Mae backed investment after only 2 years.
Eligibility for a future loan with any mortgage company for a homeowner who loses a home to foreclosure will affect their future rates and will require the prospective borrower to answer YES to question C in Section VII of the stand 1003 application that asks Have you had property foreclosed upon or given title or deed in lie thereof in the last 7 years? There is no similar question or declaration regarding a short sale.