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.

When They Stick the Knife In: The Subprime Mortgage Con

I recently got a call from a guy who wanted an FHA streamline refinance. He had already talked with two other lenders and he was then referred to me by his brother, for whom I had done a loan a few years ago.  We discussed his deal a bit and he finally asked why he should use my services. I immediately told him, "Look, there isn’t much pricing leeway on FHA loans, but if you go with me, you can be assured that I will treat you honestly."

There was a long silence as he evaluated this obviously unexpected remark. I'm sure that he was like the millions of people who get loans every year who think that they are ALWAYS dealing with someone who will not take advantage of them.

Wooops! Helloooooo! It's time for a reality check.

America is currently reeling from the economic tsunami that was triggered in part by massive borrower abuse by the subprime lenders. But it wasn't just the subprime lenders; it was a significant chunk of the entire mortgage origination industry. Even executives at otherwise ethical companies could see this highly profitable business and they could not resist the temptation to set up incentive compensation plans for loan officers that, bluntly, encouraged them to take advantage of the borrowers' ignorance wherever and whenever possible.

Even though there are enumerable laws at the federal and state levels that are designed to protect consumers, they are simply not enforced. As a result, the mortgage industry attracted tens of thousands of loan officers and executives who wanted to gorge themselves at the mortgage table without interference from pesky regulators.

So why were those loans so profitable? In large part because the borrowers were ignorant of the process and they didn't really know what they were qualified for. Every person I ever met who was involved in subprime lending said that 40 percent of borrowers would have qualified for a normal A-paper loan at attractive rates if they had just gone to a normal lender, like their bank.

The subprime lender who took the application knew this too, but his company didn't offer normal loans so he wasn’t going to say, "You ought to go to your bank." If he had said that, he would have said goodbye to that fat commission, and he certainly wasn't going do that.

Even A-paper borrowers don't understand how lenders increase their commissions by delivering above-market-rate loans. Congress thinks that "competitive market forces" will keep everyone honest. Not true. It seems that once a borrower chooses a lender, he has so much faith that he will be treated honestly that he forgets about caveat emptor – buyer beware. We now know that such trust was misplaced.

How did this happen to so many people? The simple truth is that people who are con men are good at tricking people and people are so gullible that when the loan officer stuck his knife in, the borrowers didn’t even feel it.

Randy Johnson – Author of How to Save Thousands of Dollars on your Home Mortgage and Savvy Borrower articles, Randy is a mortgage broker who has financed over $1 billion in properties. He writes about home buying and real estate finance topics for CreditBloggers.com.

Fannie's New Homeowner's Insurance Requirement for Condo Owners

Fannie Mae has just announced a new rule that is important to anyone who owns a condominium, townhome, or a unit in a Planned Unit Development (PUD). In the case of a single family detached residence, your basic insurance policy covers everything, but that’s not true in the case of a condos and similar properties.  

There are three classes of assets in any home. The first is the exterior structural components, i.e. the walls and roof. Homeowners Associations (HOAs) cover this part of the property with their master insurance policy. Generally all state laws require an association to have only a “bare walls” policy. More on what this means later.

The second class of assets includes all of your personal property including furniture, art, books, clothing, and other personal possessions. You probably already have this kind of policy.

The third class does not generally occur for people. This class of asset includes all the interior items that are still attached to the home. This includes plumbing fixtures, cabinets, interior doors, kitchen appliances, furnace, light fixtures, wall coverings, carpet or wood or stone flooring, and everything in the bathrooms.  

It is possible that assets in this third class might have slipped through the cracks as you were considering coverage. You might have thought that the Association’s policy included coverage for these items, and, indeed, some associations do, but many more do not. Some personal property policies also include some coverage, but it might be minimal.

In the event of a total loss of your home due to fire, the Association’s policy would re-build the structure but leave you with “bare walls,” as in an empty shell. If you had that minimal coverage on your personal insurance policy, it would scarcely pay for rebuilding the interior of your home the way it is now, the way you like it.

Fannie Mae and Freddie Mac have finally realized this gap in coverage and have moved to close it. In typical government fashion, this rule seems to have been made without consulting either lenders or the insurance industry. Let me see, how can I say this nicely? Oh, I can’t – it is stupid. Why?

The new requirement is that the borrower must provide what is known as an HO-6 policy, which includes “walls in” coverage. That’s okay, but here’s the stupid part. Fannie and Freddie require coverage equal to 20 percent of the appraised value of the home. It should have been written to include 20 percent of the value of the improvements. As written, you have to pay to insure 20 percent of the value of the land that is included in the total appraised value.

In a desirable area, the land is likely to be 50 percent of the total value of your home, so 20 percent of the appraised value is over twice what 20 percent of the value of just the improvements is. This means you have to pay for double the actual coverage you need. An owner of a $1,000,000 unit would be required to pay for $200,000 of coverage which might be far in excess of what the actual replacement cost is likely to be.  

Finally, this requirement conflicts with state laws that forbid lenders from requiring more insurance than is actually indicated as the realistic insurable value. In this case, state law says that owners can’t be forced to buy “excess” coverage, but a lender isn’t going to fund your loan without it. Talk about a Catch-22!

Currently this applies only to new loans, but as sure as the sky is blue, you can be sure that Fannie and Freddie are going to tell loan servicers to start making sure that each property for loans they service has this same coverage.

I hope that Fannie and Freddie will change their policy to something more realistic, so stay tuned. In the meantime, if you live in a condo or PUD, take this opportunity to get your master policy and sit down with your insurance agent to make sure your personal property assures that you are adequately insured. 

Randy Johnson – Author of How to Save Thousands of Dollars on your Home Mortgage and Savvy Borrower articles, Randy is a mortgage broker who has financed over $1 billion in properties. He writes about home buying and real estate finance topics for CreditBloggers.com.

The Credit Crunch: An Expert's Story

I've been closely covering the credit meltdown since before it began. And I've heard countless stories of job loss, bankruptcy, falling credit scores, deteriorating retirement balances, and billions in lost equity. I've interviewed hundreds of people for my stories, and I while my job is to "get the scoop", I'm always sensitive to their plight. Well, just to show you that nobody is immune from the affects of the credit meltdown, I offer you my story of loss.   

In late 2008, I bought a house in a desirable neighborhood for $282,000. That was about 15 percent below the market value at that time, so I thought I was getting a great deal. The house was in fantastic condition to the naked eye. I put 20 percent down and closed a month later. The plan was to move into it, but since we could not sell our primary home, we ended up renting it after I spent $3,800 to paint the interior.

Two weeks into my ownership, a tree from my backyard that was the size of a 737 was hit by lightening, fell, and destroyed my new neighbor’s fence. I paid to have the tree removed and offered, but was refused, to pay for the fence damage. Four weeks into my ownership, the new rental tenants told me that the house had roof rats, a fact that was not disclosed on the Property Disclosure by the previous owners. $1400 later, no more roof rats... and no more $1400.

Six weeks into my ownership, I got to buy a new dryer ($300) and paid to have a new hot water heater installed up to the current code ($600). Seven weeks later, the skies dropped a bomb in the form of constant rain. And despite the Property Disclosure clearly stating that the basement didn’t flood, it sure as heck did.

Eight weeks later, the tenants asked me for $1,000 to cover the costs of their property that was destroyed by the flooded basement. Nine weeks later they asked to be released from their rental agreement. I happily agreed, and now I have a flooding and empty home in a deteriorating housing market. $3,500 later, I supposedly had a waterproof basement, which again flooded like a submarine with screen doors the very next time it rained. And just today I accepted an offer for $245,000, just to rid myself of this white whale. After the agent’s commission and my portion of the closing costs, I will lose a little over $70,000, all in less than 12 months.

While many people would be preparing for a good stiff drink, I simply look at it this way... I’ll eventually be back on the buyer's side of that table and I’ll likely more than make up for the present loss with a future gain. Smile my friends; none of us are immune from the credit crunch.

John Ulzheimer – Credit scoring and credit reporting expert and author, John is the President of Consumer Education for Credit.com. Formerly with Equifax and Fair Isaac, John shares his unique insight of the inner workings of credit scoring models and the credit reporting industry on CreditBloggers.com.

Loan Modifications Get Messier

I have previously written about the shabby progress that is being made with mortgage modifications to help prevent foreclosures. (For more, see my last article here.) There are some interesting recent developments regarding this topic.

I also reported previously that Bank of America/Countrywide had entered into an agreement last December year with Jerry Brown, California's Attorney General, along with those of 10 other states to set aside more than $8 billion and agreed to modify a huge number of loans that were allegedly procured through questionable lending and sales tactics.

So BofA/Countrywide has this obligation. Note also that key provisions of federal legislation known as the Helping Families Save Their Homes Act of 2009 either "encourages" or "requires," depending on how you read the vaguely worded law, mortgage servicers to modify loans. So here you have this mega-lender trying to do the right thing. As soon as they entered in to the agreement, they were sued by the investors who really owned these loans. 

That's because in most cases, Countrywide may have originated the loan, but they sold it to some investor who then had an agreement with Countrywide (now BofA) to "service" the loan. Many of these servicing agreements contain provisions that Countrywide would have to buy back modified loans. And indeed, that's the issue. The investors took BofA/Countywide to federal court to get them to buy back the loans.

BofA/Countrywide took the position that provisions of the federal legislation shielded them from such suits. In fact, the law gives servicers: 

"a safe harbor to enable such servicers to exercise these authorities [modifying loans]."  

That seems clear, but that's federal law. The judge said that the investors can still pursue their cases in state courts. Who knows what state courts might rule or when it might be settled; certainly not anytime soon, for sure. And the foreclosures roll on. What a mess!

While it is clear that many lenders, including Countrywide, engaged in harsh practices that resulted in the abuse of borrowers, it sure seems to me that investors like those who are currently suing knew full well the quality of the loans they were buying. They also knew that the underwriting standards that were used were not the same ones used for "A" paper quality loans. If they had to take a loss, it should not have been unexpected and should have been part of their evaluation when they bought the loans.  

At this point, feigning ignorance and complaining about losses sounds an awful lot like, "I don’t know nuthin' about birthin' babies, Miss Scarlett." 

Randy Johnson – Author of How to Save Thousands of Dollars on your Home Mortgage and Savvy Borrower articles, Randy is a mortgage broker who has financed over $1 billion in properties. He writes about home buying and real estate finance topics for CreditBloggers.com.

What Happens to Your Account When You Say No to Rate Increases

Thanks to the Credit CARD Act, if your issuer makes a major change in the terms on your account, such as raising your interest rate, you’ll have the opportunity to opt out and pay off the card at the old terms. (I’ve described how this works in a series of blog posts this week.)

You will not have to pay your balance off immediately if you decide to opt out. However, your card issuer will be permitted to change your minimum payment. Your card issuer can choose use a method that is no less beneficial to you, the consumer, than these two methods:

• An amortization period of not less than five years; and
• A required minimum periodic payment that includes a percentage of the balance that is not more than twice the prior percentage

In other words, they can’t force you to pay off the card in less than five years or require a minimum payment that is more than double your current minimum payment. However, if your minimum payment has been extremely low, you could see an increase if you decide to opt out of a change in terms.

Separately, the proposed rules also require your card issuer to give you advance written notice if your minimum payment will increase, but the issuer will not be required to allow you to reject the higher minimum payment.

On the one hand, the Fed has to look at safety and soundness issues. If consumers have credit card debt that stretches out for decades, there is a good chance these consumers will fall into default. On the other hand, many consumers I’ve spoken with who defaulted on their cards did so after their minimum payments rose.

Gerri Detweiler – Personal finance author and Credit Advisor for Credit.com, Gerri contributes budgeting, debt recovery and savings information online. She is also the co-author of Reduce Debt, Reduce Stress: Real Life Solutions for Solving Your Credit Crisis.

Want to Lock in a Better Credit Card Rate? Not So Fast…

The Credit CARD Act changes that go into effect on August 20, 2009 are small potatoes compared to the major changes that will take place in February of 2010. In fact, the Federal Reserve Board summarizes them in just three bullet points on their press release.

Of course, 107 pages of details accompany that press release. (I can’t wait to see what I get to wade through when the next round comes along.)

To their credit, the regulators have to consider all kinds of arcane but possible scenarios. And one of those scenarios jumped out at me as deserving mention. As background, recall that after August 20, 2009, you will get 45-days advance written notice of a major change in terms on your credit card account and you’ll have the chance to opt out of the new terms. (You may or may not be required to close your account.)

Here’s the scenario that caught my attention: Let’s say I get a notice that my credit card company is going to raise my fixed rate of 9.9 percent to a variable rate that works out to 17.99 percent. I can opt out and maybe my issuer will let me still keep the card. Realizing my rate is going to jump on new purchases after the change takes effect, I go on a shopping spree, locking in my current purchases at 9.9 percent.

The Fed says this isn’t exactly fair to issuers, so they are going to allow issuers to charge you the higher rate on any individual purchases you make 14 days or more after the notice of the change in terms is sent to you.

So here’s another scenario: I receive that notice, but it goes into my pile of mail to read, and I put off reading it. I continue to use my card, only to later discover that I have made those purchases at the new higher rate, even though it hasn’t really gone into effect yet.

So word to the wise – even after the 45 days notice goes into effect, you have to pay attention, immediately read notices that your card issuers send you, and act accordingly.

Gerri Detweiler – Personal finance author and Credit Advisor for Credit.com, Gerri contributes budgeting, debt recovery and savings information online. She is also the co-author of Reduce Debt, Reduce Stress: Real Life Solutions for Solving Your Credit Crisis.

Challenging Your Property Taxes Part II

I opened my email on Monday morning to find a message from a reader taking me to task about my last post on challenging your property tax assessment. She not-so-gently pointed out that you don't have to pay for advice to do this. All you have to do is contact your local property tax assessor's office. It´s a valid point, but it's not always quite that easy. For example, I am in the process of challenging the assessment on property I own out of state and will probably end up having to hire an attorney to help me with that one. That being said, and as my reader pointed out, challenging your property taxes is very often a do-it-yourself project that need not cost you a penny.

Her email prompted me to dig up an article by Credit.com, How to Cut Your Property Taxes, that will walk you through the basics. Although Nancy Castleman wrote the article a few years back, it's even more timely now, with property values dropping in many parts of the country. I'd love to hear what you think, and learn about your experience challenging your tax assessment.

Gerri Detweiler – Personal finance author and Credit Advisor for Credit.com, Gerri contributes budgeting, debt recovery and savings information online. She is also the co-author of Reduce Debt, Reduce Stress: Real Life Solutions for Solving Your Credit Crisis.

Are Your Property Taxes Too High? Challenge Them!

$43 billion in property values has vanished over the past two years in Sarasota, Manatee, and Charlotte counties in Florida, according to a recent article in my local newspaper. If that's not painful enough, we still have to pay property tax bills that may not accurately reflect what our homes are worth.

Or maybe not. At least that's the message Valerie Faltas, creator of the Little Black Book of Property Values, wants to share.

Valerie is a Certified Property Tax Appraiser who worked for the Los Angeles County Tax Assessor’s Office for over four years. During that time she assessed over 6,000 properties. She was also a licensed residential fee appraiser in California.

She's written The Property Tax Little Black Book in both national and California editions. (The California edition is the more detailed of the two, since the author worked there and has direct experience in that market.)

Her basic premise is that property tax appraisals are handled by overworked agents who may be well-trained but don't have a lot of time to evaluate each property individually, and who certainly don't have the time to go over each property's assessment in detail. Mistakes can be made, and if the mistakes are not in your favor, you'll pick up the tab. 

In fact, as I was flying home from a business trip recently, I overheard a woman describing how she discovered that her parents had been overpaying on their property taxes for years. Turns out they had gone to the tax assessor's office a couple of decades ago to find out how their property tax bill would change if they put in a tennis court. They never did add the tennis court, but the assessor changed their property description based on that inquiry -- and they had never caught the change in their bill!

If the value of a property you own has dropped, you owe it to yourself to make sure you aren't overpaying on your taxes as well.

Gerri Detweiler – Personal finance author and Credit Advisor for Credit.com, Gerri contributes budgeting, debt recovery and savings information online. She is also the co-author of Reduce Debt, Reduce Stress: Real Life Solutions for Solving Your Credit Crisis.

And the Crowd Moved On

One of the least attractive features of human personality is the tendency to focus on something for a very short period of time, and then move on to the “next big thing”. We seem to have this ability to get incredibly interested in an issue – arguably titillated by it – and then, shortly thereafter, we forget.

Remember the first O.J. Simpson trial? Researches actually were able to detect a slight drop in the Gross Domestic Product while people who should have been working were watching the trial on TV. Then he was acquitted and everyone moved on to something else.

Americans are generous, as we witnessed with the outpouring of donations to the Red Cross after disasters like Hurricane Katrina. We also get emotionally involved, exemplified by humanitarian crises like the ongoing tragedy in Darfur. People were once quite supportive of the relief efforts there, but not so much anymore. Today it’s just another tired story that people don’t want to hear anymore. The crisis there is just as bad, but the public just isn’t interested anymore. It’s old news.

We have seen this some problem manifested in the media coverage of economic news in the current economic crisis. For while it was all about mortgages. That is where it started and it was news. No one had heard about this before. First we had the implosion of companies like New Century. Every morning you could go check the Implode-O-Meter to see the latest count of mortgage-related companies that had imploded. When I first started looking at it, the count was 23. Now it is 327 and, I might add, no one seems to care any more.

What happened here was a media-driven firestorm that was spurred on by the use of terms like “subprime mortgage.” Those words have an emotional effect different from “loans to previously underserved markets.” What made it all the more juicy were the tales of 20-something loan officers making million-dollar commissions while shoving unqualified borrowers into over-priced homes using toxic loans the borrowers could not afford. That was a prescription for disaster, although back then no one could conceive that the final dimension of the problem would be a global financial meltdown.

During the height of the coverage there were four or five stories about the mortgage crisis in the newspapers every day. Some were sober analyses and some were tawdry; others were blatantly sensational. But the public has a limited appetite for such news. You can only read about stories about another 100,000 homeowners losing their homes to foreclosure until the numbers blur and people stop paying attention.

As a result, the public has moved along to other economic disasters: the crash in property values in over-heated markets, the decline in the stock market that saw trillions of dollars in peoples’ 401(k)s evaporate. Next we had the bloodbath on Wall Street with collapse of Lehman Brothers, Bank of America’s purchase of Countrywide and Merrill Lynch, J P Morgan Chase’s purchase of Washington Mutual, Wells Fargo’s purchase of Wachovia, and the failure of IndyMac Bank. All of that was news – at least for a while.

Next our attention shifted to Bernie Madoff and the largest Ponzi scheme in history with something like $50 billion of wealth wiped out. Then we moved on to executive compensation – senior executives in financial firms who paid themselves upwards of $18 billion in bonuses even as their companies imploded.

As of early February 2009, it seems as if the newest crisis du jour is the economic stimulus package that is being run through Congress.

It is not clear whether this package includes something to help individual homeowners avoid foreclosure. Personally, I think that ought to be at the top of the list because that is the only way we are going to stem the flow of foreclosed properties onto the market. The existence of too many foreclosed homes in any area creates further downward pressure on the rest of the market.

The other borrower-friendly feature in the proposal, the one that would have allowed bankruptcy judges to modify home mortgages, has bitten the dust.

Will the public debate ever get back to talking about mortgages and housing? I sure hope so, because I do not see how we can get out of this mess without restoring health and confidence to the lending market. To achieve any progress, we need to have a meaningful dialogue about it.

It’s easy to point fingers at executive compensation, where you can show executive’s pictures and describe how much they got paid. You know the audience will get incensed seeing a few people being unjustly enriched when so many others are suffering from foreclosures and unemployment.

It is much harder to understand the current mortgage situation because it is so diffuse. Who is the ultimate owner of a loan? Who services the loan? What authority do they have to renegotiate loan terms? Who wrote the credit default swap on the contract? Is that company still viable? What is the value of the loan portfolio?

Those are very difficult questions, and answers are exceedingly difficult to come by. As you know, the press does not typically have correct answers to complicated questions. Stay tuned. Hopefully the crowd and the media will turn its attention back to mortgages and housing in the near future.

- Randy Johnson