Strategic Default: The Real Cost of Walking Away from Your Mortgage

A University of Arizona law professor has raised eyebrows for urging homeowners who owe more than their houses are worth to act in their own self-interest by walking away from their mortgages. 

Professor Brent T. White argues that underwater homeowners could save hundreds of thousands of dollars defaulting on their mortgages in his academic paper titled “Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis.”  

To do so, they must overcome their moral qualms about refusing to pay their bills. White argues that this moral barrier was constructed by a variety of players, including the government, the financial industry, and social control agents like banks and media.  

The short-term costs of walking away -- including a negative hit to one’s credit score -- are outweighed by long-term financial benefits, he says. 

“While the actual financial cost of having a poor credit score for a few years may be hard to quantify, it is not likely to be significant for most individuals, especially not when compared to the savings from walking away from a seriously underwater mortgage,” he says.  

Which raises the question: When homeowners strategically default on mortgages -- that is, skip payments even though they can pay their bills -- what exactly happens to their credit? White cautions borrowers, telling them they can expect to take a 100- to 150-point hit to their credit scores, with additional hits for late payments. The total hit from late payments and a foreclosure could be as high as 300 to 400 points. Plus, it takes seven years for a foreclosure to disappear from one’s credit report entirely.  

However, he says that “one can have a good credit rating -- meaning above 660 -- within two years after foreclosure" by staying current with other creditors. And qualifying for a federally-insured FHA loan to buy another home can happen in as little as three years.  

But other people -- ranging from walkaway borrowers to lenders and credit experts -- say the hits you take are deeper and more long-lasting than White suggests.  

“A default will have a serious negative impact on a consumer’s credit score and make it more difficult to obtain future credit,” said Barrett Burns, president and CEO of VantageScore Solutions, a scoring company created by the three national credit bureaus, Experian, Equifax and TransUnion.  

“That negative impact will vary depending on what action the consumer takes to avoid further default.”   There are a number of other options, beyond defaulting, available to underwater homeowners: loan modifications, short sales, foreclosures, and bankruptcies. Those who are current on their payments and have a positive loan-to-value ratio may inquire about refinancing to seek better terms.  

Loan modifications reduce a borrower’s monthly payments by decreasing the interest rate, rolling late payments and fees into the principal, or extending the life of the loan. These strategies make the loan more affordable.  

However, the rate of re-defaults after a loan modification are quite high, according to an October report by the Office of the Comptroller of the Currency and Office of Thrift Supervision.  

The report shows that a quarter of all borrowers who received loan modifications in the first quarter of 2008 re-defaulted three months later. And more than half who received loan modifications in earlier quarters re-defaulted after a year.  

An increasingly prevalent strategy is to lower the principal on the loan, according to the report. Principal reduction was used 3.1 percent of the time in the first quarter of 2009. That percentage jumped to 10 percent in the second quarter, statistics show.  

Loan modifications may have little effect on credit scores. A short sale, on the other hand, can adversely affect a score by 120 to 130 points, VantageScore has said. But it will have a less negative impact than a foreclosure, Burns said.  

“A consumer who has defaulted may face higher interest rates and/or more restrictive terms and conditions when borrowing in the future or may be prevented from obtaining credit altogether,” he said.  

Indeed, it will take a minimum of five years (not three, as White claims) to qualify for a federally insured FHA loan to buy a new home, officials at Fannie Mae and Freddie Mac told Washington Post’s Kenneth R. Harney. Harney has reported that people who file for bankruptcy protection covering all of their debts (mortgage, credit cards, auto loans, etc.) will get hit with an average 355- to 365-point drop in their scores. Bankruptcies remain on borrowers' credit bureau files for 10 years.  

The Vantage credit score rates borrowers on a scale range of 501 (subprime, the highest risk) to 990 (super-prime, the lowest risk). It competes with the Fair Isaac Corp.’s FICO scoring system, which ranges between 350 and 850. In general, a FICO score of 650 is considered a “fair” credit score, while 750 or higher is considered “excellent.”     

Cristine Gonzalez — A freelance writer specializing in family and personal finance, Cristine has worked as a reporter and copy editor for The Oregonian in Portland, Ore., The Associated Press, and People magazine in New York City.

Comments

[Loan Modification]

What time saver! Thank you for putting everything relevant to this subject in one place so that I don’t have to surf all over the place to collect it. Having the material presented by an experienced professional is an added plus. Loan Modification

[been there dealing with it right now!]

One other thing you didn't mention is the deficiency judgments that many small banks and mortgage lenders are now seeking against the defaulting homeowner(s). If your house sells at the foreclosure sale for $100,000.00 less than you owe on it, you can, and now more often than not, will be liable for the deficiency, court costs, attorney fees, etc.

[Sarasota Realtor]

So far, debt owners are not pursuing deficiency judgments.

Officially, a previous commenter ("been there dealing with it right now!) makes a good point.

Whether walking away or short selling, the deficiency judgment remains a reality...(IF) you have the capacity now or later to pay deficiency amount (that is, the difference b/t what the property sells for and what is owed + all the fees added to foreclose or sell).

Having worked MANY short sales, I am not (today) seeing debt owners pursue collections. HOWEVER, each state's statute of limitations determine just how long a debt owner can pursue collections.

There's a legislative move to remove this possibility, however, to stimulate (short) sales and motivate borrowers to help short sell the property.

The other concern many borrowers have about "losing" or "walking away" from a property is how the IRS treats this situation. If you have used the property as your principal residence, you have NO tax implication under the Homeowner Tax Forgiveness Act. On the other hand, if the property was investment, second or vacation, you stand to have the IRS tax you on the "forgiven" amount.

That is, you owe $300,000. Property sells for $150,000. Debt owner (might) 1099 you for the difference ~$150,000 and the IRS (could) tax the $150,000 at your taxable rate. Of course, this is a question for you tax expert just as your real estate questions need to be passed by a real estate attorney familiar with your state's laws.

For instance, Florida (where I am) is a "judicial" foreclosure state; whereas, California is a "NON judicial" foreclosure state. In CA, it's either the property or the borrower the debt owner CAN go after, not both as in Florida.

Mike