Strategic default: Is it OK to walk away?
- Owners question the wisdom of making payments on deeply underwater homes.
- Default is increasingly viewed less emotionally and more strategically.
- First, consider the financial consequences of strategic default.
When David Valadez walked away from his home loans, he drew some criticism. Friends told him: "You have a contract with the lender and it's wrong to quit paying your mortgage just because your property lost value."
His response: "Yes, I signed a contract. It's a business contract, and business contracts are broken all the time."
The lender foreclosed on Valadez's condominium unit in San Jose, Calif., a few months ago. Looking back, Valadez says he's glad he was able to view the strategic default as a financial decision, not an emotional one.
"I'm very relieved that I got that white elephant off my shoulders," he says.
Unlike borrowers who can't afford to keep up with their mortgage payments, strategic defaulters have the ability to pay but choose to walk away.
Valadez, a retired teacher, says he earns enough to afford the more than $2,000 monthly payments on his two home loans. But he didn't think it made financial sense to sink more money into a property that was valued at $130,000 when his mortgages totaled more than $300,000.
Keep paying or let go?
Valadez's story is familiar to millions of homeowners who are current on their house payments but owe much more on their mortgages than their properties are worth. More than five years into the housing crisis and despite recent improvements in home prices, these homeowners wonder whether they should continue to pay their mortgages or simply let go and walk away.
"They are looking at their property values and saying 'It's been four or five years and I still have a lot of negative equity, so maybe it makes financial sense to walk,'" says Jon Maddux, co-founder and former CEO of You Walk Away, a company that, for a fee, guides homeowners through strategic default.
Unlike in the early days of the financial crisis, underwater homeowners have been putting their emotions and morality questions aside and are increasingly viewing strategic default as a business decision, Maddux says.
"There's definitely less emotion and more strategy in their thinking," he says.
Right versus wrong
As with Valadez, strategic defaulters often face strong criticism because of the notion that their default hurts neighborhoods and property values even more.
But homeowners considering strategic default quickly rebut the morality question by pointing to large institutions that have opted for strategic default on commercial properties and developments.
One example often cited by supporters of strategic defaulters is one of the biggest mortgage defaults in history. In 2010, real estate giants Tishman Speyer Properties and BlackRock Realty defaulted on $4.4 billion in loans on two major apartment complexes in New York City's Manhattan, letting the lender take over the properties after the development had lost about half of its value.
"It happens all the time," Valadez says. "It's a free economy. This is simply a business decision."
Strategic default through business lenses
As with every business decision, homeowners should carefully consider the financial consequences of strategic default, says Robert Stone, senior business consultant at Experian's Decision Analytics.
Walking away from your mortgage harms your credit substantially, Stone says. A homeowner with a credit score in the high 700s could see a drop of as much as 100 points after going delinquent, he says.
Strategic defaulters generally have excellent credit scores up until the time of default, Stone says.
"They are sophisticated, rational investors who saw their equity disappear," he says.
Alternatives to strategic default
Homeowners who want to let go of their mortgages should to try to get a loan modification or reach another agreement with the lender to minimize the impact on their credit score, Stone says. Consider a deed-in-lieu of foreclosure, which involves turning the property over to the lender without going through the foreclosure process. Requesting a short sale, when the lender allows the homeowner to sell for less than what is owed on the mortgage, also is an alternative.
"Those are considered to be slightly better outcomes than a foreclosure," Stone says.
Trying to work out an agreement with the lender didn't work for Valadez.
"I called the lender at least five times and each time I was told I made too much money," says Valadez, who now works as a salesman.
If you walk, plan ahead
If you find that your only option is to walk away, like Valadez, plan accordingly.
Many strategic defaulters open new, high-limit credit card accounts before they default. Others get mortgages and buy cheaper homes before they let go of their underwater property, Stone says.
When you know your credit will be damaged, it's wise to stash away some money before default, says Valadez. He saved what would go toward his mortgage payments while waiting for the foreclosure to be completed.
"I knew my only clear option was strategic default, so I prepared myself for that and I made sure I had money in the bank," he says.
He says he kept up with homeowners association payments and insurance while living at the condo.
Depending on which state you live in, you should consider whether the lender can sue you to collect the balance of the loan after the foreclosure is completed. If the lender sues and obtains a deficiency judgment against you, the debt can haunt you for years.
For Valadez, that wasn't an issue because California laws prohibit lenders from pursuing deficiency judgments on purchase loans. In many states, lenders have years to file a lawsuit against the borrower.
"Know all the consequences before you make a decision," Maddux says.