The housing crisis has created far too many unwanted consequences and trends that have hampered a swift and seamless economic recovery. Coming on the heels of the subprime mortgage meltdown and the contraction of mortgage credit, the 'great recession' produced an unprecedented decline in the value of homes. Those falling home prices have left millions of homeowners in an "underwater" position, where their home is worth far less than the amount of the mortgage they owe on the property.
Faced with what seems like unrecoverable levels of home equity, some underwater borrowers will pay their loans down for years and still only get back to a position of owning nothing (0% equity); other underwater borrowers have simply decided to walk away – a.k.a strategically default -- from their mortgage, even though they can still afford to make their monthly payments.
Some borrowers feel they have little recourse. With an underwater position, they don't qualify for a traditional refinance. If they aren’t already behind on their monthly payments, they’re likely not eligible for a federally-sponsored loan modification either. Whether right or wrong, some borrowers feel that with no other avenues for assistance, simply walking away represents their best chance to start over.
Even Freddie Mac’s Executive VP Don Bisenius agrees strategic defaults “might well be a good decision for certain borrowers.”
Walking away from your home loan shouldn’t be a decision that’s made overnight. Strategic defaults can come with a host of short- and long-term repercussions, including some of which you might not be aware of. There are both pros and cons to walking away from your mortgage, and it's a good idea for you to be aware of both before you consider a strategic default as the solution to your problem.
5 Reasons to Walk Away
You’re underwater: The number one reason borrowers strategically default on their mortgage is because they are underwater. Given the substantial drop in home prices over the last few years, an estimated 25% of all homeowners have negative equity in their homes. According to a recent Federal Reserve study, “the median borrower does not strategically default until equity falls to -62 percent of their home's value” (e.g. your home is worth $124,000 and the mortgage outstanding is $200,000). Given how far some borrowers’ equity has fallen, the underwater problem will be with us for years to come. Recently HSH.com ran some numbers and determined that a significant portion of borrowers wouldn’t even reach 0% equity until 2015.
The same home, or more, for less: While many homeowners may struggle with the moral dilemma of not paying their debt, walking away from your mortgage is a business decision. Whether you decide to walk away from your mortgage or refinance your mortgage, the ultimate goal is to significantly change your financial situation. According to the Wall Street Journal, some borrowers have successfully been able to walk away from underwater homes and rent similar properties in the same area for half the cost of their mortgage. The decision to walk away is all that much easier when you can keep your surroundings, lifestyles and neighborhoods intact and find a house that meets all of your needs for far less money each month.
Free yourself of debt and build savings: In states where lenders can’t go after your assets for money owed to them (non-recourse states), walking away from your mortgage can free you from a mountain of debt. Freeing yourself from your mortgage may allow you to completely recast your budget, so that you can pay off other debts (i.e. credit card, automobile loan), save for retirement and get your fiscal situation in better shape. If you decide to default, it’s probably also a good idea to take advantage of the improvement in cash flow by putting the money you save into a high-yield savings account for when the time comes when you can buy again, should you wish to.
Less responsibility: Aside from the stress of being a financial burden, owning a home can be a physical burden as well. There’s no doubt about it: Many homeowners look back fondly at the days when they rented instead of owned. Can you recall the days when it snowed and you didn’t have to worry about bundling up to shovel the sidewalk and the driveway? Or how about all the times you didn’t have to go out in the summer heat to cut the lawn or trim the bushes?
The reality is that, as a homeowner, maintaining the appearance and condition of your home is just one of your many responsibilities and expenses. Homeowners who decide to walk away wipe their hands of these financial pressures and obligations and can go back to the simpler days of less responsibility and fewer demands on your time and money.
Bypass the short-sale process: A short sale gives you the opportunity to surrender your home back to the bank without leaving the ugly, long-lasting mark of a foreclosure on your credit history. But that about sums up all that’s positive about the short-sale experience. The short-sale process can be a long and frustrating one for the buyer and seller alike. In this process, the bank has complete control over how much your home sells for, and there are plenty of stories around about how eager buyers are turned away or withdraw due to lengthy delays and refused offers. Simply walking away allows you to skip this potentially-frustrating process entirely.
5 Reasons Not to Walk Away
You’ll kill your credit: Walking away from your mortgage is one of the quickest and easiest ways to kill your credit score. Money Magazine says a borrower with a credit score of 780 who decides to walk away will see their score drop by up to 150 points. Given the widespread use of credit scores today, a drop in your credit score could prevent you from getting a new job, renting an apartment and will increase your interest costs now and well into the future.
You can’t own again for years: Strategic or not, if you default on your mortgage it will take years before you can get another mortgage. Foreclosed borrowers can expect to wait anywhere between two and five years before they are eligible to get a new mortgage. Borrowers who voluntarily walk away may have to wait twice as long. Fannie Mae recently announced their plans to lock strategic defaulters out of new loans for seven years! However, in an attempt to encourage borrowers to work with their lenders to produce less-costly outcomes, as of July 1, 2010, Fannie Mae cut in half the amount of time short sellers have to wait to become owners again. Borrowers who sell their homes via a short sale will only have to wait two years.
Tax implications: If you walk away, the IRS may make you pay taxes on your forgiven debt, which they treat as income. “People think their house was underwater, so they’re insolvent and can get out of owing taxes,” Arthur Auerbach, a member of the Individual Income Tax Technical Resource Panel at the American Institute of Certified Public Accountants, told the Wall Street Journal. “But it doesn’t work that way.” The IRS treats canceled debt like added income. In the IRS’ view, if you borrow “-x-” amount of dollars from the bank and then never pay it back, you are way ahead of where you started financially. Incurring a huge tax bill is an unexpected “going away present” when you walk away from your home and mortgage.
Protecting your assets: The most-common definition for strategic default is choosing not to make your mortgage payments, even though you can afford to. In recourse states -- states where lenders can go after borrowers for money owed to them – you could find yourself in a world of financial hurt after walking away from your mortgage obligation as lenders look to collect the difference (called deficiency) between what you owe and what they recover by selling your former home. This pain probably won’t happen immediately, either; it could be a year or two years (or more) before lenders get through acquiring and selling your property to determine their loss. Then they’ll come after your other assets, including savings accounts, automobiles, second homes, wages, etc.
According to NJ.com, “Experts predict that mortgage companies will begin to sue homeowners in the next two years, including borrowers who ransack a house that has been lost to foreclosure and those who walk away from ‘underwater mortgages’...”
Trouble renting: So you’ve walked away from your underwater mortgage and now you’re looking to rent. That was your game plan at least: walk away from your “over-priced” home and rent something similar for half the cost. However, the credit crisis has caused everyone from credit card companies to landlords to take a greater interest in their customers’ credit. A foreclosure can slash your credit by up to 150 points, and might prevent you from renting a new place to live and could even wind up inflating your rent to boot.
Whether valuable or not, there is no doubt that walking away from your home is a thorny issue. Given the always-uncertain housing market, you may ultimately do better by hanging on and hoping that property-price appreciation fills in some of the gap between what you owe and what your home is worth. If that’s unpalatable, you should strongly consider opening a dialogue with your lender or servicer to see if there are any cost-lowering or even principal-reduction options available to you. Before you strategically default, you should also consider talking to a real estate lawyer and other professionals about the legal and financial ramifications of walking away. Contemplating a more graceful exit may put you in a better position to conduct fiscal damage control and prepare for the future.
Our purpose was to really think around the issue of strategic defaults, not advocating for one position or another. While we did tackle a host of considerations, we were hoping you could let us know which considerations we missed.
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Tim Manni is the Content Editor of HSH.com and is the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.