As home prices continue to plummet and unemployment remains a huge problem, more and more homeowners are turning in the keys to their homes and refusing to make any more payments on their mortgages. However, walking away from an underwater mortgage, known as strategic default, has long been a subject of controversy and often viewed as highly irresponsible– until now.
In the wake of a collapsed housing market and sluggish economic recovery, a few noted finance authorities, including Suze Orman, have actually come out and recommended the practice of strategic default.
So, how can a supposed finance expert condone walking away from a financial obligation and purposely ruining your credit and reputation as a borrower? According to Orman, it comes down to a simple calculation.
Suze Orman Advice: Guide on Walking Away From a Mortgage
According to Orman, you should stick it out and continue to pay off your mortgage if your home is 10-20 percent underwater. However, if the balance on your mortgage is 20 percent greater than the value of your home or more, it isn’t worth paying off.
Step one should be to ask your lender to modify the loan and reduce the principal owed.
If they refuse, which they likely will, your next course of action is to ask for a short sale. If they don’t agree to that, try a deed-in-lieu of foreclosure.
Still get a “No?” Orman says this is when you should be walking away from your mortgage at this point, and you shouldn’t feel bad about it since you asked your lender for help and they refused.
Suze Orman Advice: Walking Away From Your Underwater Mortgage on The View
The Repercussions of Walking Away From Your Mortgage
A strategic default, and subsequent foreclosure, leaves a nasty mark on your credit profile. Consequences include:
- Drop in Credit Score: Foreclosure results in a penalty of approximately 85-160 points, according to Fair Issac, which means even a borrower with good credit can easily slip into the sub-prime category.
- 7-Year Listing: Foreclosure stays on your credit report for seven years, which means your score will remain damaged for this period of time.
- Cash Is King: Securing a loan of any sort will be very difficult. Your existing credit cards should go unaffected as long as you stay current on the balance, but overall, you will have to save up and pay cash for everything.
The repercussions of turning in the keys are severe and long-lasting, yet many strategic defaulters would rather live with those consequences than keep making payments on an underwater mortgage.
Should You Keep Making Mortgage Payments?
There are a number of convincing arguments for and against strategic default, though you may consider some weightier than others.
Why Walking Away From Your Mortgage Could Make Sense
Advocates of strategic default say it is really about making the best possible business decision. Why continue to pay thousands of dollars toward an investment that is no longer worth it, when you can rent a home for much less and save the difference?
While a foreclosure will stay on your credit for seven years, making it virtually impossible to get a decent loan or line of credit, you can use that time to save up and start over.
By renting a house for less, you can apply the new income toward other outstanding debt instead. You can even put a little cash aside for a down payment and apply for a mortgage again later. Seven years from now, you will have built your credit back up and saved for a home that has (hopefully) rebounded in value and become a viable investment once again.
Professor Brent T. White of the University of Arizona advises the financial benefits of walking away from a severely underwater mortgage far outweigh the short-term affect on credit. As explained on Credit.com, the only thing holding homeowners back is “their moral qualms about refusing to pay their bills…this moral barrier was constructed by a variety of players, including the government, the financial industry, and social control agents like banks and media.”
Why You Should Continue Making Mortgage Payments
Aside from the devastating effect on credit, walking away from your home loan poses a number of serious concerns.
The major issue behind strategic default is that you ignore your ethical obligation to uphold the terms of your loan. Our credit system relies on the trust between lenders and borrowers, and if people applied the same logic to other types of loans as they do when it comes to underwater mortgages, no one would ever feel obligated to pay back any of the money they owe.
In fact, allowing your home to be foreclosed helps drive down your neighbors’ home values as well, contributing to the problem and lengthening the recovery of your local housing market.
If you’re not experiencing a significant financial hardship like unemployment or a medical emergency, it’s hard to justify walking away from a mortgage simply because it’s underwater.
Alexandra Swan, Vice President of Frontier 2000 Mortgage & Loan, writes for her blog,
“appreciation or depreciation on the house is just a number that changes arbitrarily. When properties were appreciating at a skyrocketing pace, no homeowner ever went back to their mortgage company and said, ‘I know I bought this house for $200,000 and I financed $150,000 but now it is worth $500,000.00 so I think I owe you some additional money.’ So why, in the reverse situation, should the bank lower your principal simply because the value has dropped?”
As Swan points out, you wouldn’t quit paying your auto loan, even though you know it will only depreciate in value as soon as you drive it off the lot.
Secondly, consider all of the money that you’re essentially throwing away. You’ve made expensive mortgage payments for years, and by walking away from your home, you’re also walking away from your investment.
After all, an overvalued home is probably better than being in the hole a couple hundred thousand dollars with nothing to show for it. The housing market will recover some day–so who cares if your home’s value doesn’t catch up to the mortgage until 20 years into your 30-year fixed loan?
Finally, there will soon be severe tax penalties for defaulting. Walking away from your mortgage loan doesn’t mean you get a slap on the wrist and then go on your merry way. At the end of 2012, a federal tax break for short sales and foreclosures is set to expire, which means you’ll be required to pay income taxes on the remaining loan balance.
If you get lucky, you can use strategic default to your advantage, walking away from a poor investment now and saving for a better one years down the road. Many homeowners have done it, and many more probably will.
However, even the “experts” get it wrong sometimes (Orman is not a licensed investment advisor, by the way). It’s probably not a good idea to walk away from your home simply because it is undervalued–in this case, you’ll likely trade one unpleasant financial situation for another that’s even worse.
Photo credit: Freedom To Marry