We’ve been told to never walk away from our problems, but what if walking away is the most logical solution? When it comes to an underwater mortgage—where the money you owe on the house is higher than the current market value—some homeowners choose to cut their losses.
Referred to as strategic default or strategic foreclosure, the decision to abandon your home loan is a workaround that some homeowners use to get out of a bad investment. Although controversial, there are times when voluntarily bolting on your mortgage based on declining values might make economic sense.
“During the foreclosure crisis, when property values plummeted, strategic default was the term used to describe borrowers who remained able to pay their mortgage, but made a calculated, strategic choice to stop paying,” says Charles Castellon, attorney at Widerman Malek, in Celebration, FL. “The strategic decision to default is fundamentally a business decision to cut losses.”
During the most recent financial crisis, negative equity in the U.S. peaked at 26% in the fourth quarter of 2009, according to CoreLogic. Today, 4.2% of mortgages are still underwater.
But how does a strategic default work, and how will it affect a homeowner’s creditworthiness?
How strategic default works
The process of a strategic default is fairly straightforward. After making the calculations and realizing your home value pales in comparison to the principle left on your mortgage, homeowners simply stop paying. And if lenders are not getting their money, sooner or later they’ll foreclose on the home.
“To strategically default, you stop paying the mortgage until the lender forecloses and repossesses the property,” says Tendayi Kapfidze, chief economist at LendingTree in New York.
Relevancy to today’s homeowners
Castellon says the concept of strategic default remains relevant since people will always suffer economic hardship, regardless of the strength of the overall economy.
“Strategic default was a hot topic during the low point of the foreclosure crisis and may make a comeback after the next market correction,” says Castellon. “During hard times, they may not be able to pay all of their obligations and are forced to engage in triage. This involves determining the likely consequences that will come from defaulting on certain debts and deciding who to pay and who to stop paying.”
How defaulting affects your financial future
Of course, defaulting on a mortgage means you’ll take some sort of hit to your credit score. That’s why anyone considering strategic default should understand the consequences it can have on their financial future. When buying another home or even renting, lenders and landlords may be more discriminating based on your record.
“Any default will affect your credit score, and a foreclosure will remain on your report for up to seven years,” says Kapfidze.
However, he says, many borrowers who default, strategically or otherwise, can purchase a home again in as little as two years.
“Given that strategic defaulters did not do so because of cash flow challenges, they are likely to service other debts well and thus see recovery in their credit score faster than borrowers with additional financial challenges,” says Kapfidze.
Pros and cons of strategic default
Before you choose to walk away and let your property go into foreclosure, it’s important to understand the pros and cons of this decision.
“The benefits of the strategic default include getting out of bad debt and containing the financial damage. It’s all about mitigating losses and damage control,” says Castellon.
It’s important to note that strategic default is not without risk though—having one in your financial history can harm your credit scores and make it harder to get another loan down the road.
And, in some cases, lenders pursue borrowers for deficiency judgments. A deficiency judgment is the difference between the amount a borrower owes on the loan and the foreclosure sale price.
“In my experience, a very small percentage of my distressed mortgage clients have had to face a deficiency claim, but it has been known to happen,” says Castellon.