Strategic Default: When It Makes Sense to Walk Away From Your Home
In a strategic default, you let your home go into foreclosure because it's a bad financial decision to keep it. Learn the pros, cons, and alternatives.
In recent years, some borrowers have considered strategically defaulting on a mortgage loan once the home has become a bad investment. This is different from how many people view foreclosure -- as something that happens only when a homeowner can no longer afford the mortgage payments. Read on to learn more about strategic default, the consequences of such a default, and alternatives to simply walking away from a distressed property.
What Is Strategic Default?
Many properties have become so far underwater (where you owe more than your home is worth), that it could take years before the home regains all of its value, if it ever does. In some cases, borrowers choose to stop making payments, even if they could afford to stay current, simply because the home has become a bad investment. This is known as strategic default, which is sometimes called voluntary foreclosure or “walking away.”
Generally, the term “strategic default” implies a different a situation than a homeowner who is struggling financially and cannot afford to keep paying the current mortgage payments. (See our article When Foreclosure Threatens: Can You Afford to Keep Your Home?) With a strategic default, the borrower does the math and makes a business decision to voluntarily stop making payments, even if it is within their ability to keep up on the payments.
After the homeowner voluntarily stops making payments, the lender is forced to foreclose. Learn more about how foreclosure works.
Downsides to Walking Away
If you are contemplating a strategic default, you should know the consequences and take them into consideration as part of your decision-making process.
With a strategic default, you may be liable for a deficiency judgment depending on your state’s laws.
When a lender forecloses on a mortgage, the total debt owed by the borrower to the lender frequently exceeds the foreclosure sale price. The difference between the sale price and the total debt is called a “deficiency.”
Example. Say the total debt owed is $200,000, but the home only sells for $150,000 at the foreclosure sale. The deficiency is $50,000.
In some states, the lender can seek a personal judgment against the borrower to recover the deficiency. Generally, once a deficiency judgment has been obtained, the lender may collect this amount (in our example, $50,000) from the borrower by doing such things as garnishing wages or levying a bank account.
(To learn more about deficiency judgments in the foreclosure context, see our Deficiency Judgments After Foreclosure area.)
Many of the states that were most impacted by the housing crisis, such as California, are states with nonrecourse laws. This means that in most circumstances, a lender cannot seek a deficiency judgment. However, other states, such as Florida, do allow deficiency judgments. To find out the deficiency laws in your state, see our State Foreclosure Laws section.
Difficulty Getting a New Loan
If you strategically default, you won’t be eligible for a Fannie Mae-backed mortgage for seven years from the date of the foreclosure. Fannie Mae has also stated that it will take legal action to recoup the outstanding mortgage debt from borrowers who strategically default on their loans in jurisdictions that allow for deficiency judgments.
Significant Credit Score Drop
A foreclosure will not ruin your credit score forever, but it will have a significant impact on your ability to obtain another mortgage for quite some time, generally three to seven years. Fannie Mae, which backs many home mortgages, has stated that anyone who has strategically defaulted will be ineligible for a Fannie Mae-backed mortgage for seven years from the date of the foreclosure.
Additionally, a foreclosure will impact your ability to get other forms of credit, like a car loan, and affect the interest rate you receive as well.
Learn more in Foreclosure and Your Credit Score.
Future Housing Issues
If you plan on renting a house or apartment after a strategic default, bear in mind that it is standard for landlords to review your credit report when deciding whether or not to rent to you. The rental market is more competitive than it used to be and the landlord may be able to select a renter with better credit over you.
Stigma of Foreclosure
While foreclosure has lost much of its social stigma, many employers routinely run credit checks on potential employees. Since a foreclosure will appear on your credit report, it certainly could cause issues for your job prospects. Of course, this depends on the employer and, to some extent, the reason for the foreclosure. For example, if you are applying to work at a water treatment facility and can show extenuating circumstances (such as you had serious medical issues that led to the default), the potential employer will probably take that into consideration when contemplating hiring you. However, if you are applying for a job in the financial services or banking industry, a bad credit report may very well affect your ability to get the job. The potential employer may think that if you could not manage your own money, you will not be able to competently handle someone else’s.
Moral Implications of Strategic Default
Arguably, there are moral implications associated with walking away from an underwater home as well. Strategic defaulters tend to justify walking away from a severely underwater home as something permitted by the mortgage contract itself, which specifies the consequence of a breach, namely, the lender will foreclose and take the home. However, when you signed the promissory note, this constituted a promise to pay. (Learn more about mortgages and promissory notes.) Some consider it to be immoral to voluntarily break this promise. Others do not.
Alternatives to Strategic Default
In the past, there weren’t that many viable options out there to help borrowers with their underwater mortgages. However, now there are more lender-based and government-based programs that can provide assistance. Some of these options are:
- Short sales. A short sale is when you sell your home for less than the total debt balance remaining on your mortgage and the proceeds of the sale pay off a portion of the mortgage balance. (Learn more about short sales.) However, keep in mind you may be subject to a deficiency judgment if you complete a short sale. See our article How to Avoid a Short Sale Deficiency Judgment for more information.
- Deeds in lieu of foreclosure. A deed in lieu of foreclosure occurs when a lender agrees to accept a deed to the property instead of foreclosing in order to obtain title. With a deed in lieu of foreclosure, you could face a deficiency judgment as well. The deficiency amount is the difference between the fair market value of the property and the total debt. (Learn more about deeds in lieu of foreclosure.) Starting March 1, 2013, Fannie Mae and Freddie Mac will let some borrowers who are current on their payments give up their underwater properties and cancel the debt under their Mortgage Release and Standard Deed in Lieu of Foreclosure programs, if the borrower meets certain criteria.
- FHA Refinance for Borrowers with Negative Equity (FHA Short Refinance). If you are underwater on your mortgage and would like to obtain more favorable mortgage terms, you might want to consider an FHA Short Refinance. If you qualify, your lender would reduce the amount you owe on your first mortgage to no more than 97.75% of the home's current market value. Learn more in our article Help for Homeowners with FHA Loans.
- HARP refinance. HARP (Home Affordable Refinance Program), which is part of the government’s Making Home Affordable initiative, is a program that allows eligible underwater homeowners who are current on their mortgages to refinance and take advantage of lower interest rates. HARP will not reduce the principal amount you owe, but would provide a more stable or affordable loan. Learn more in our article The Home Affordable Refinance Program.
- Modify the loan to make it more affordable. Approach your mortgage servicer or lender to find out if they will modify the loan to make it more affordable. Learn more about loan modifications and other options to avoid foreclosure in our Alternatives to Foreclosure area.
If you want to find out more about available programs that may be able to assist you, call your loan servicer. For more information on programs available under Making Home Affordable for underwater homeowners, go to www.makinghomeaffordable.gov and select “Explore Programs,” then choose “If Your Home’s Value Has Fallen”.