Strategic Default & Foreclosure: What Happens If You Walk Away From Your Mortgage

If your home has become a bad investment and your mortgage is underwater, you might be considering defaulting on your loan payments (even if you can still afford to make them) and letting a voluntary foreclosure happen. This tactic to rid yourself of a bad real estate investment is called a "strategic default" or a "voluntary foreclosure," and is most common in states where mortgage loans are nonrecourse.

Strategic defaults were common during the foreclosure crisis from around 2007 to about 2014, though they're less frequent now. In this article, you'll 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 on a Mortgage?

Sometimes a property is so far underwater that it could take years before the home regains all of its value. If that happens, borrowers sometimes choose to stop making their mortgage payments, even if they could afford to stay current, simply because the home has become a bad investment. This decision is known as a "strategic default," which is also sometimes called "voluntary foreclosure" or "walking away."

Strategic Default vs. Regular Default

Generally, the term "strategic default" implies a different situation than a homeowner who's struggling financially and can't afford to keep making the mortgage payments. With a strategic default, the borrower does the math and makes a business decision to voluntarily stop making payments, even if it's within their ability to stay current on the loan. After the homeowner voluntarily stops paying, the lender forecloses.

However, in some cases, a borrower who's struggling financially might decide it's a wise decision to stop trying to keep the loan current and just let the home go into foreclosure. This situation usually isn't referred to a "strategic default."

Consequences of Default

Going into default and letting a foreclosure happen damages the borrower's credit and can carry other financial consequences, including potentially a deficiency judgment or tax liability on forgiven debt. (See below for more negative consequences after a strategic default.)

Strategic Default vs. Strategic Foreclosure

With a strategic default, the homeowner decides to stop making mortgage payments and let a foreclosure happen. A strategic default leads to a strategic foreclosure.

Again, the terms "strategic default" and "strategic foreclosure" imply the borrower can afford the mortgage payments, but has made the decision to quit paying, even though they're contractually obligated to do so based on the mortgage and promissory note they signed. So, these terms have a bad connotation in the mortgage industry.

Most defaults and foreclosures aren't strategic. Typically, a homeowner falls behind in payments and faces foreclosure after suffering some kind of financial hardship, like the loss of a job or the death of an income-earning spouse. So, generally, if you're facing a foreclosure because of financial difficulties, and considering letting the house go into foreclosure, you might want to avoid calling it "strategic," especially if you're still trying to work out an alternative to foreclosure with your lender.

Example of a Strategic Default and Foreclosure

Thomas owes $500,000 on his home, but the house is worth just $250,000. He can afford the payments but sees that it will take many years to recover his lost equity. Continuing to pay his mortgage is a bad financial investment because the value of the other homes in his neighborhood are dropping similarly, and a market recovery isn't on the horizon. Thomas decides to stop making payments and let the lender foreclose so he can get out of having to repay the mortgage loan.

Who Typically Considers Walking Away From Their Mortgage and Doing a Strategic Foreclosure

Homeowners with significant negative equity (underwater mortgages) sometimes consider walking away from their mortgage and doing a strategic foreclosure.

Strategic defaults and foreclosures surged during the 2008 financial crisis. In many cases, people who could afford to continue making their mortgage payments simply decided their homes were bad investments and let a strategic foreclosure happen. Sometimes, people with good credit who had never missed a mortgage payment took out new loans to buy less-expensive houses with smaller mortgage payments and then strategically defaulted on their more expensive properties.

Strategic defaults sometimes still occur in markets with declining real estate values. These days, homeowners who bought homes in the past few years, particularly in 2021 and later during times of high home prices, are at greater risk of having an underwater mortgage and are more likely to consider a strategic default. Also, strategic defaults are common in tough economic times when real estate investors see the value of their real estate holdings fall drastically.

When It Might Make Sense to Do a Strategic Foreclosure

Some sources say that a strategic default might make sense if your home is worth at least 25% less than you paid for it. But in most cases, that figure should be more like 50%. That's because your house's value would have to appreciate by as much as it dropped for you to come out even, which would likely take a significant number of years. Still, keep in mind that the real estate market has historically recovered and gained value, even after a crash.

Or if your real estate is merely an investment and you won't see a return on that investment for years, it might make sense to consider a strategic default. And, if you bought your house with no down payment (or almost none) or took out an interest-only loan, you had no equity to begin with, so you wouldn't lose any equity by walking away.

One study by the Federal Reserve looked at a specific period during the foreclosure crisis and examined at what point borrowers were likely to strategically default. Here are their results:

The study found that the median borrower doesn't walk away until they owe 62% more than their home's value. Transaction costs, potential legal consequences, credit damage, and market recovery hopes keep most homeowners from strategically defaulting.

However, in all cases, strategically defaulting and letting a foreclosure happen can lead to some serious negative consequences. And there might be a better option (such as a loan modification or selling the home) instead of a strategic default.

Consequences of Strategic Default and Strategic Foreclosure

If you're contemplating a strategic default, you should know the consequences and consider them as part of your decision-making process.

You Might Have to Pay a Deficiency Judgment

In a foreclosure, the borrower's total debt might exceed the foreclosure sale price. The difference between the sale price and the total debt is called a "deficiency." For example, say the total debt owed is $300,000, but the home sells for $250,000 at a foreclosure sale. The deficiency is $50,000. In some states, the bank can seek a personal judgment called a "deficiency judgment" against the borrower to recover the deficiency. Generally, once the bank gets a deficiency judgment, it may collect this amount (in our example, $50,000) from the borrower using standard collection methods, like garnishing wages or levying a bank account.

With a strategic default, you might or might not be liable for a deficiency judgment after a foreclosure. Deficiency judgment state laws determine what will happen after a strategic default and foreclosure. If a state has anti-deficiency laws, a foreclosing bank can't seek a deficiency judgment under specific circumstances.

Some states, like California, for example, have anti-deficiency laws, so you can probably walk away from your home without liability. Most homeowners in California won't face a deficiency judgment after a foreclosure. Other states, like Florida, for example, allow deficiency judgments.

Tax Implications of Strategic Default

If the lender forgives the deficiency after a foreclosure, that canceled amount might be considered taxable income to you unless you qualify for an exclusion or exception. Be sure to consult with a tax adviser if you're considering a strategic default.

Significant Credit Score Drop

A foreclosure won't ruin your credit forever, but it will have a considerable impact on your credit scores, as well as your ability to qualify for another mortgage. Also, a foreclosure could impact your ability to get other forms of credit, like a car loan, and affect the interest rate you receive as well.

Waiting Period to Qualify for Another Mortgage

You might have trouble getting a new mortgage loan if you walk away from your home. In the past, Fannie Mae, for instance, has stated that strategic defaulters won't be eligible for a Fannie Mae-backed mortgage for seven years from the date of the foreclosure. Fannie Mae also said 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.

Future Housing Issues

If you plan on renting a house or apartment after a strategic default, remember that it's standard for landlords to review your credit when deciding whether to rent to you. The rental market is competitive, and a landlord might be able to select a renter with a better credit history than you.

Employment and Financial Background Checks

While foreclosure has lost much of its social stigma, many employers routinely run credit checks on potential employees. Because a foreclosure will appear on your credit reports, it could cause issues for your job prospects when you go through the employment screening process.

Of course, whether having a foreclosure on your credit reports will affect your options depends on the employer and, to some extent, the reason for the foreclosure. For example, suppose you're applying to work at a supermarket. In that case, a foreclosure probably won't hurt your employment chances. But if you're applying for a job in the financial services or banking industry, having bad credit could very well affect your ability to get the job. The potential employer might think that if you couldn't manage your own money, you won't be able to handle someone else's competently.

Moral and Social Implications of Strategic Default

Arguably, some moral implications are associated with walking away from an underwater home. Strategic defaulters tend to justify walking away from a severely underwater property as something permitted by the mortgage contract, which specifies the consequence of a breach. (Specifically, the bank can foreclose.) But when you signed the promissory note, you promised to repay the loan. Some people consider it immoral to break this promise voluntarily. Others don't.

Alternatives to Strategic Default and Foreclosure

Some options to consider instead of strategically defaulting are:

• Do a short sale. A "short sale" is when you sell your home for less than the total debt remaining on your mortgage loan, and the proceeds of the sale pay off a portion of the balance. However, you might be subject to a deficiency judgment if you complete a short sale. Try to get your lender to forgive the deficiency. (Keep in mind, you might have to pay taxes on the canceled amount, depending on the circumstances.)
• Complete a deed in lieu of foreclosure. A "deed in lieu of foreclosure" is a transaction where the bank agrees to accept a deed to the property instead of foreclosing. With a deed in lieu of foreclosure, you could also face a deficiency judgment. The deficiency amount would be the difference between the property's fair market value and your total debt. Try to get the lender to accept the deed in lieu of foreclosure in full satisfaction of the debt.
• Modify the loan to make it more affordable. You could approach your loan servicer to see if it will modify the loan to make it more affordable until the market improves.
• File for bankruptcy. Filing for bankruptcy can eliminate foreclosure-related liabilities and other debts, making it easier to afford your home payments. Talk to a bankruptcy lawyer to find out if this option might make sense for your circumstances.

Planning Before a Strategic Default

If, after reading this article and learning about the negative consequences of a strategic default, you're still considering that option or planning to go that route, you should carefully prepare for the financial, legal, and practical consequences before proceeding. You should:

• learn the foreclosure laws in your state and whether you're safe from a deficiency judgment
• build up your cash reserves as a buffer to cover moving expenses, legal fees, and other living expenses (such as a security deposit for rental housing)
• if you need them, open new lines of credit while your credit scores are still good to ensure access to credit after you default (strategic default and foreclosure will cause a big drop in your credit scores)
• explore housing alternatives, and
• get advice from professionals, including a tax professional and a lawyer. Again, strategic default can have legal, tax, and financial consequences, and you need to understand the risks of taking this approach.

Preparing for the aftermath of a strategic default and voluntary foreclosure can help minimize the damage and protect your financial future.

Step-By-Step Strategic Default and Strategic Foreclosure Process

Here's a step-by-step of what happens with a strategic default and voluntary foreclosure.

1. Evaluate options and consequences. You should first assess your financial situation, get professional advice, and plan for the default and foreclosure as discussed above.

2. Make the decision to strategically default. After evaluating costs, benefits, credit impacts, financial consequences, and future plans, decide to stop making payments.

3. Default on mortgage payments. After you stop making your mortgage payments, the lender will eventually start a foreclosure, typically after 120 days.

4. Foreclosure proceedings come next. How long the process will take depends on state foreclosure procedures, the foreclosure process used (judicial vs. nonjudicial), and the circumstances. The borrower may live in the home until the foreclosure is complete. You might consider looking into foreclosure alternatives (loss mitigation options) with the lender. This can prolong the foreclosure process and prevent you from being labeled a strategic defaulter, perhaps resulting in a shorter waiting period for a new mortgage.

5. Post-foreclosure. After the foreclosure sale, you might be able to stay in the home during a redemption period. Once you move out, you can start rebuilding your credit and deal with a deficiency judgment (if applicable).

Where to Get Advice About Strategic Default

If you're considering a strategic default, talk to a foreclosure lawyer and tax professional to learn about different alternatives and consequences applicable to your situation. There might be a better option available.