More than one out of every five homeowners in the United States is burdened by an underwater mortgage. Unfortunately, there's not much they can do about it.
An article in The New Yorker by James Surowiecki claims that while businesses—namely, American Airlines—are praised as making smart financial decisions when they walk away from expensive debts, homeowners are shamed into dumping money into homes that are worth much less than the loans backing them.
Paying these underwater mortgages, Surowiecki argues, is equivalent to setting cash on fire every month. The values of many homes have dropped to the point that it no longer makes financial sense to keep them—and if more homeowners were to strategically default on their home loans and refuse to continue paying into these bad investments, lenders would be forced to provide more aid to the borrowers they put in this position in the first place.
Surowiecki isn't the first to take this stance, however. Brent White, a law professor at the University of Arizona, made the same claim a couple of years ago and even published a book in 2010 entitled Underwater Home: What Should You Do if You Owe More on Your Home than It's Worth? In what has been referred to as "Walking Away From Your Home for Dummies," White writes:
"You aren't barred from collecting on an insurance policy if your insurance company miscalculates the chances of a tornado and wishes that they had charged you more. If your lender miscalculated the risk of a housing collapse and borrowers defaulting as a result, that's the lender's error. It will be more careful next time. But you still have an option to default."
He also discusses the apparent double standard for individuals versus business entities and their debts, and says that when it comes to an underwater mortgage, emotion shouldn't play into the homeowner's decision regarding how to handle it—even though it usually does.
Guide to Strategic Default
There is an incredible amount of controversy surrounding strategic default and whether or not it's the right thing to do. Some believe that anyone who has agreed to the terms of a home loan is obligated to stick to that commitment, regardless of the home's current value. Others consider a home to be an investment, and should be treated as such, thereby making strategic default an entirely financial—not ethical—decision.
Surowiecki and White, of course, take the latter stance. If you, too, believe your home is an investment, and are considering walking away from it, here's how to do it.
Decide When It's Time to Walk Away
It's important to understand that purposely defaulting on your mortgage is only really strategic when your home is underwater, and the money you're currently spending on loan payments would be best put toward another expense. Simply owning an expensive house that you struggle to afford is not a situation in which you should walk away.
But don't say goodbye to your house just yet—the difference between your home and mortgage values should also be large enough to warrant defaulting. If you don't walk away, you would continue paying it off and wait for property values to rise again. Some industry experts endorse walking when you're as little as 20% underwater, but there are so many issues surrounding whether or not walking is a viable option that our in-house CFPs warn not to even consider it before you're 25% under. (And that doesn't mean you walk away—at 25%, you may want to start considering it as an option.)
Determine the Legal Impact
The state in which you live could mean the difference between little more than a slap on the wrist and a lifetime of financial troubles. A handful of states are "non-recourse" states with anti-deficiency laws, meaning a lender can't take you to court in an attempt to recoup anything beyond the collateral backing your loan (i.e. your house).
Non-recourse states are: Alaska, Arizona, California, Connecticut, Iowa, North Carolina, North Dakota, Minnesota, Montana, Oregon and Washington.
However, most states are recourse states, and if you live in one, a lender can take serious legal action against you if you default on your home loan. Actual lawsuits are rare because they're time-consuming and costly for lenders, but they do happen. It's best to consult a real estate lawyer to find out if you're at risk, even if you live in a non-recourse state.
Determine the Financial Impact
Even if you live in a non-recourse state, there are also a number of financial consequences related to strategic default that may or may not be of concern to you. Ask yourself the following questions to decide if you can handle the financial impact that follows a foreclosure:
- Will rent be cheaper than the mortgage? Strategic default is really only worth it if it helps you save some money. You should be able to rent for less than it costs to own your home, otherwise, you remain in the same financial situation—minus a house and good credit.
- Can I live on cash? Speaking of credit, your score will take a hit of around 200 points. That would put even the highest of credit scores into the "poor" range. If you see a new car or student loans on the horizon, defaulting on your mortgage will make those things an impossibility, at least for the next few years.
- Do I have job security? Poor credit doesn't just affect your ability to secure low interest loans. Employers are increasingly turning to credit checks as a way to screen job applicants. Poor credit often means a long road ahead if you're job hunting.
- Am I prepared to pay taxes? When you are no longer responsible for paying a debt, it effectively becomes income—according to the IRS, anyway. "Discharge of indebtedness" on a big mortgage balance could result in a hefty tax bill, so speak with a tax professional about your liability before walking away.
The Dangers of Default
Deciding whether or not you should walk away from your mortgage boils down to performing a cost-benefit analysis in which emotion is not considered. But before you send your lender jingle mail, you should understand that defaulting on your mortgage—strategically or otherwise—involves potentially devastating consequences. Businesses that decide to walk away from their debts can still post generous profits the following year, but there is a possibility you could end up financially ruined for doing the same.
The choice to walk away from your mortgage should not be made hastily or alone. Hundreds of thousands of homeowners have done it, but you should consult a financial professional who is familiar with your situation before joining them.