What is a Strategic Default?
A strategic default is when a homeowner consciously defaults on their mortgage payments and literally walks away from the home (both physically and financially) despite either: a) having the ability to make their payments, or; b) because they do not work with their lender in good faith exploring alternatives to foreclosure.
People commit strategic defaults for a number of reasons, however, the primary one is because their mortgage is underwater, meaning they owe more on the house than the house could sell today in the open market. By the end of 2011, approximately 48 percent of the 50 million mortgage loans nationwide are predicted to be underwater or valued less than the money owed on them. There are also published estimates that more than 11 million American homeowners are underwater and predictions are that the number could more than double in the next 18 months!
To illustrate an example of an underwater mortgage, assume a homeowner bought a house four years ago for $500K with 0% down. Because of falling home values in his neighborhood, the home is now only worth $300K.There is a good likelihood that home values in that neighborhood will never be what they once were so he will never be able to recoup the entire amount of his purchase price.
Some people that are using strategic defaults are doing so because they have become so exasperated at their lenders for not doing more to help them such as a loan modification. Anyone who has ever tried to get a loan modification would probably be the 1st to admit that lenders do not make it easy for a borrower to get one. Often times borrowers can’t get responses from banks to their questions and are repeatedly told to send in the same documents over and over again.
You’re Mortgage is Underwater. Should You Walk Away?
The primary reasons for a strategic default are cash preservation, savings protection, and wealth protection. People do not want to waste their cash on a worthless asset or a bad debt.
A few years ago, asking someone if they would walk away from their mortgage was really a fringe question for a fringe audience. Nowadays, though, 25% of all residential mortgages are underwater. In states like Nevada and Florida – two of the epicenters of the housing bubble and subsequent bust – more than half of borrowers owe more on their mortgages than their homes are worth. In other words, for a growing portion of homeowners, this question is of foremost importance.
For argument’s sake, let’s assume that you have already discussed a loan modification with your lender, and you have been either rejected or presented with an inadequate offer. As a result, you have made the decision to part with your home. [Admittedly, this is a weighty decision]. Should you sell your home at a loss, or simply walk away from your mortgage and allow your lender to deal with the fallout?
The first option is known as a “short sale,” since the proceeds from the sale of your home wouldn’t be enough to cover the balance of your underwater mortgage. Accordingly, a short sale (or its first cousin, the deed in lieu of foreclosure) first requires the approval of the lender, because it is tantamount to writing off part of the mortgage as a loss. Still, many lenders are amenable to this possibility, because it is often less complicated – and hence, much less expensive – than outright foreclosure. You will also need the approval of all junior-lien lenders as well as the mortgage insurance company, if applicable. After receiving an offer on your home, this must then be submitted to the lender (via its loss mitigation department) for final approval.
If your house has depreciated too much in value, and/or your lender is not willing to approve a short-sale, then a strategic default might be your last option. So-called as to distinguish it from a “conventional” foreclosure, a strategic default is a voluntary decision to stop making mortgage payments despite the capacity to do so. While choosing foreclosure might strike some as oxymoronic, it turns out that for many, it is actually a perfectly rational choice. Simply, the negative impact on one’s credit score and the possibility of a deficiency judgment, pales for some when weighed against the prospect of spending the rest of one’s lifetime paying off a mortgage that is well underwater. Read further down this article for a list of negative consequences that should be considered though when deciding if a strategic default is right for you.
New Fannie Mae Rule Penalizes Homeowners who Strategically Default on Loans
Fannie Mae, which owns or guarantees more than 50 percent of mortgages in the U.S., announced in a press release on June 23, 2010 that it was cracking down on homeowners who strategically defaulted on their home mortgages, saying that borrowers who default despite having ability to pay or do not seek alternatives in good faith won’t be eligible for a new Fannie Mae-backed mortgage for seven years from the date of foreclosure.
In the press release, Terence Edwards, executive vice president for credit portfolio management at Fannie Mae, said “Walking away from a mortgage is bad for borrowers and bad for communities, and our approach is meant to deter the disturbing trend toward strategic defaulting. On the flip side, borrowers facing hardship who make a good faith effort to resolve their situation with their servicer will preserve the option to be considered for a future Fannie Mae loan in a shorter period of time.”
In addition, Fannie Mae said in the press release that it will also sue to recoup the outstanding mortgage debt from borrowers who strategically default on their loans in jurisdictions that allow for deficiency judgments. In an upcoming announcement, the company will be instructing its servicers to monitor delinquent loans facing foreclosure and make recommendations for strategic default cases that warrant the pursuit of deficiency judgments.
Given the fact that Fannie Mae is going to seriously crack down on strategic foreclosures, looking at short selling your home could be a more logical solution.
The only conundrum when looking at a strategic default vs a short sale is whether or not the lender will let you complete one. In many situations lenders will not let you short sale your home unless you have a financial hardship. In my experience, I have seen quite a few lenders that are not enforcing the hardship qualifications aspect of a short sale as you would expect. Is it harder to get a short sale done without a hardship? It certainly is but not impossible.
Why is a Strategic Short Sale better than a Strategic Default
Let’s look at several ways in which a strategic short sale is preferable to a strategic default.
- Although both a short sale and default will negatively impact your credit rating, the short sale will not affect it as badly as a foreclosure will.
- Opting for a short sale will allow you to qualify for a decent mortgage with two years as opposed to a strategic default of a loan insured by Fannie Mae as they will not allow a homeowner who has committed a strategic default to qualify for a new Fannie Mae backed mortgages until 7 years after the foreclosure.
- Many banks, because of the state of the economy, will be willing to accept the property’s current market value and consider it “payment in full.” This is preferable to them over the time and costs involved in foreclosing on the property.
Negative Consequences of Strategic Defaults
Owing more on a mortgage than one's house is worth may seem like a bad investment. But the alternative - choosing to default on a mortgage even if you can afford the monthly payments - will take a significant toll on a credit rating.
"Strategically defaulting - deciding to stop paying your mortgage regardless of your ability to actually carry the debt - will have a far-reaching, long-lasting impact on your ability to secure future credit," said Maxine Sweet, vice president of public education for global information services company Experian. "It's by no means a move to be undertaken lightly."
About 355,000 borrowers strategically defaulted in the first half of last year, according to research conducted as part of the Experian-Oliver Wyman Market Intelligence Reports. Interestingly, Experian and Oliver Wyman found that the homeowners most likely to strategically default were also those with the highest credit scores.
While it may seem like a good move to simply stop paying and walk away from a bad investment, keep several factors in mind when considering a strategic default.
- It's very final. Strategic default will lead to foreclosure by the lender. Foreclosure will negatively impact one's credit report and scores. In fact, only bankruptcy will affect credit scores more adversely than foreclosure.
- The default will remain on one's credit report for seven years. Since credit scores are based on information in the credit report, the foreclosure will greatly impact one's credit scores during those seven years. Securing other credit at reasonable terms and rates will be very difficult, if not impossible, during that time.
- Potential lenders aren't the only ones looking at credit reports these days. Insurers, employers and even cell phone companies are considering the creditworthiness of those who want to do business with them. As a result, a strategic default may affect one's ability to get a job, secure insurance and enter into important service contracts.
- The debt that foreclosure "erases" may be recorded as income, which means you will have to pay taxes on it.
Strategic default may seem like 'walking away' from a bad debt, but it's really not as you will almost certainly pay in other ways in the form of lowered credit scores and a drastically curtailed ability to secure future credit for the next seven years. Higher interest rates and unfavorable terms could end up costing you more in the long run than continuing to pay on an upside-down mortgage.
Having said all this, the only remaining consideration is the moral one - deliberately breaking a contract that you have the ability to honor. While there are strong arguments to be made for both sides, in some cases you will just have to let your conscience be your guide.
What is an SFR?
The complex details involved with short sales and foreclosures are unique calls for specialized expertise. Contact an agent such as myself that has earned the Short Sale and Foreclosure Resource (SFR) Certification through the National Association of Realtors and who is committed to helping you understand your options so you can make the best possible decisions for you and your family.
If you are in a situation where your home is “underwater” due to falling home prices, you are unable to make your current mortgage payments and you are considering pursuing options such as a short sale, deed in lieu of foreclosure, strategic default or even foreclosure, there could be drawbacks that I, as a real estate agent, cannot advise you on. For your protection, I suggest that all borrowers:
- Obtain legal advice from a competent real estate lawyer regarding deficiency judgments
- Call an accountant or CPA to discuss short sale and foreclosure tax ramifications
Except for certain conditions pursuant to the Mortgage Forgiveness Debt Relief Act of 2007, be aware the I.R.S. could consider debt forgiveness as income, and there is no guarantee that a lender who accepts a short sale or foreclosure will not legally pursue a borrower for the difference between the amount owed and the amount paid. In some states, this amount is known as a deficiency. A lawyer can determine whether your loan qualifies for a deficiency judgment or claim.
