Sometimes borrowers consider 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.
Sometimes a property is 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 that happens, borrowers sometimes 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 Should I Try to Keep My Home or Let Foreclosure Happen?)
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 forecloses.
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 might be liable for a deficiency judgment after the foreclosure, depending on your state’s laws.
When a lender forecloses on a mortgage, the total debt owed by the borrower to the lender can exceed 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 sells for only $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 Deficiency Judgments: Will You Still Owe Money After the Foreclosure?)
Some states, like California, have nonrecourse laws. This means that in most circumstances, a lender cannot seek a deficiency judgment. However, other states, like Florida, do allow deficiency judgments. (To find out if the lender can get a deficiency judgment in your state, see our Key Aspects of State Foreclosure Law: 50-State Chart.)
Fannie Mae 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 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.
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. 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 about how a foreclosure affects your credit score.)
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 competitive and the landlord might be able to select a renter with better credit over you.
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 report, it 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.
But if you're applying for a job in the financial services or banking industry, a bad credit report could 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.
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.
Some options to consider rather than strategically defaulting are:
To find out if you're eligible for an alternative to foreclosure, contact your loan servicer. If you need information about how foreclosure works in your state, consider talking to a foreclosure attorney.