Will borrowers walk away from their mortgages just because they're underwater?
In the last few years, home prices have fallen exponentially -- by about 30%. This massive drop in prices has depleted homeowners' equity, resulting in millions of borrowers owing more on their mortgages than their homes are worth. I'm sure you've heard of this infamous phenomenon, it's known as being "underwater" on your mortgage. As the number of underwater borrowers grew, so did the number of homeowners who simply walked away -- a.k.a. strategically defaulted -- from their mortgages (voluntarily defaulting, even though you can still afford to make the payments).
To hedge against this increasing problem, everyone -- from homeowners, to mortgage lenders, to market analysts -- has been trying to determine at what point a borrower makes the decision to walk away. Is there an exact amount at which home prices need to fall before a borrower decides to walk away? Is an underwater borrower an automatic threat to strategically default?
Can Walk Aways be Predicted?
The short answer is no.
The perception is that just because a borrower is underwater, that means they'll walk away. That's not necessarily true. Being underwater is generally a contributing and very influential factor, but it's not the only reason a borrower will default on purpose.
John Krainer and Stephen LeRoy of the Federal Reserve Bank of San Francisco say that the decision to walk away hinges on a combination of things: life events, home-price appreciation, costs, as well as being underwater. Furthermore, Krainer and LeRoy are of the opinion that the vast majority of underwater borrowers choose to stay in their homes as opposed to walking away.
Walk Aways Always Existed
The truth is, borrowers have always walked away from their mortgages, just far less than they do right now. Life events such as divorce, illness or unemployment have always influenced borrowers' decisions to walk away, write Krainer and LeRoy. Yet, it's the addition of a substantial loss of equity -- triggered by the massive drop in home prices -- that has caused the nationwide increase in strategic defaults since 2006.
Being able to sell your home for a profit or at least break even was always the saving grace for homeowners who experienced a life event which caused them to want or need to give up their mortgages. However, when home prices plummeted, homeowners no longer had that option, prompting more borrowers to walk away.
Yet, the hope that home prices will rise again in the near future, returning at least some of the equity they lost in the downturn, keeps most borrowers in their homes (at least for now) explains Krainer and LeRoy. They contest that this upside (regaining home values) trumps the downside of further home-price depreciation, resulting in more underwater borrowers deciding to stay put. Absent another trigger or reason, simply being underwater doesn't mean you'll walk away.
As we've noted several times before, the decision of whether or not to walk away is regarded as a "business" decision. Meaning, as with any business decision, the homeowner weighs the pros and cons and considers all the costs associated with either staying or walking.
In our article, "The pros and cons of walking away from your mortgage," we discussed that the costs and repercussions associated with walking away can be extensive and long-lasting. For one, there's your credit to think about. On top of that, you have to understand that walking away could ruin your chances to own a home or even rent an apartment for years to come. Those are even more reasons why the majority of underwater borrowers decide against walking away, say Krainer and LeRoy:
Such an analysis assumes that, when homeowners default, they turn over the keys to the lender with no further obligation or cost. In fact, default brings with it a variety of transaction costs, including moving expenses and the cost of a lower credit rating. Borrowers will factor these costs into their default decisions. Such costs further lower the optimal default point, sometimes by a wide margin.
Last Friday we wrote that "If the White House doesn’t act quickly to introduce something besides their FHA Short Refi program [the most recent attempt at helping underwater borrowers refinance], this country could be faced with another wave of voluntary foreclosures."
While the Economic Letter written by Krainer and LeRoy disputes the notion that "another wave" of strategic defaults is going to occur, there's no disputing the fact that life events combined with the current lack of home price recovery will lead to more underwater borrowers walking away; especially if Washington can't find a viable solution to help these borrowers refinance.
In conclusion, according to Krainer and LeRoy, fewer underwater borrowers walk away than many of us may believe. When it comes to whether or not we can predict exactly when a borrower will walk away, the answer to that question is still "no, we can't." That said, we do know for sure that while underwater borrowers are far more likely to walk away as opposed to those with positive equity positions, being underwater isn't the sole reason borrowers walk, but it's a contributing and very influential factor for sure.
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Tim Manni is the Content Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.