If your home has become a bad investment, you might be considering defaulting on your mortgage payments, even if you can still afford to make them, and letting a foreclosure happen. This tactic to rid yourself of a bad real estate investment is called a "strategic default."
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.
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."
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 bank forecloses.
It might make sense to give up your house if it's now worth at least 25% less than you paid for it, and you can't afford the monthly payments. That's because your house's value would have to appreciate by as much as it dropped for you to come out even, and that will likely take several years. Also, there's no point in putting time and effort into keeping your house if you truly can't afford it.
What if you bought your house with no down payment (or almost none) or took out an interest-only loan? In that case, you had no equity to begin with—so right now you could give up the house without losing much financially, right? It's true that you wouldn't lose any equity by walking away, but you could end up liable for a "deficiency" (see below) and face other negative consequences.
If you're contemplating a strategic default, you should know the consequences and consider them as part of your decision-making process.
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."
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, depending on your state's laws, you might be liable for a deficiency judgment after a foreclosure. Or, depending on state law, you might be safe from a deficiency judgment.
Some states, like California, for example, have anti-deficiency laws. If a state has anti-deficiency laws, a foreclosing bank can't seek a deficiency judgment under specific circumstances. Most homeowners in California won't face a deficiency judgment after a foreclosure. Other states, like Florida, for example, allow deficiency judgments. To find out if the bank can get a deficiency judgment in your state, see our Key Aspects of State Foreclosure Law: 50-State Chart.
You might have trouble getting a new mortgage loan if you walk away from your home. 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.
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.
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.
While foreclosure has lost much 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.
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 telecommunications company. In that case, a foreclosure might not hurt your employment chances, especially if you can show extenuating circumstances like you had serious medical issues that led to the default.
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.
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.
Some options to consider instead of strategically defaulting are:
Contact your servicer to find out if you're eligible for an alternative to foreclosure. If you need information about how foreclosure works in your state, consider talking to a foreclosure attorney.