By Thomas M. Anderson | October 2010
Some homeowners who can afford to pay their loans are choosing not to.
Jeff Horton did a gut check. The 33-year-old information-technology manager had been dutifully making the monthly mortgage payments on his three-bedroom home and on a condo he rented out for investment income, both in the suburbs of Orlando. But he felt trapped. His properties were worth about half of the $395,000 he had paid for them at the top of the market. In September 2009, after months of soul searching, Horton joined the ranks of borrowers who practice "strategic" default: He stopped paying on both mortgages, even though he could afford them.
"I was raised Southern Baptist. The decision was a moral struggle," says Horton. "My mom had a hard time dealing with it. But I didn't want to be tied down for five or seven years waiting to break even."
Breaking a deal. Some 1.65 million homeowners received default notices in the first half of 2010, according to RealtyTrac, an online marketplace of foreclosed properties. It's impossible to tell how many of those defaults were strategic, but one recent study from credit bureau Experian and Oliver Wyman, a consulting firm, estimates that fewer than one-fourth of homeowner defaults are discretionary. Meanwhile, about 20% of mortgages, or roughly 15 million homeowners, are underwater -- they owe more on their mortgages than their homes are worth -- and are candidates for default, strategic or not.
Shame, guilt and the anxiety over a foreclosure's consequences prevent more borrowers from taking the plunge, says Brent White, a law professor at the University of Arizona who has studied strategic default. Plus, as the housing market improves, the default numbers are declining. Homeowners who can't keep up with payments can pursue a mortgage modification or, if that doesn't work, a short sale (selling your home for less than you owe on the mortgage with the lender's okay). Call your lender to negotiate, or go to makinghomeaffordable.gov. Horton says he tried to refinance, but the lender wasn't interested because his properties had fallen so much in value.
But some view a home purchase as a business deal that you should be able to unwind should it go south. YouWalkAway.com, the San Diego firm that helped Horton with his default, has advised more than 5,000 borrowers about default since 2008. "We want to help our clients avoid bankruptcy, if possible," says Jon Maddux, YouWalkAway's co-founder. Maddux says he spends much of his time persuading his customers that they are not bad people for bailing on their mortgages. The site charges a flat fee of $1,000 or offers a trio of payment plans that start at $200 down and $30 per month. For the money, customers receive details on how the default process works and meet with a lawyer and an accountant to discuss legal and financial options.
The fallout. There are benefits to defaulting. While the bank pursues foreclosure, borrowers pay off other debts and save money as they live in their homes free. Horton is reducing his credit-card debt and paying down
student loans, as well as contributing $200 more per month to his retirement plan. Given the backlog of underwater properties nationwide, the foreclosure process can take more than a year to complete. It took nearly a year after his last mortgage payment for Horton's condo to be auctioned off, and as of early August he hadn't heard from the bank about foreclosing on his home.
But walking away will make it harder to buy a home in the future. Under new rules, Fannie Mae, which backs loans from lenders, prohibits borrowers from receiving government-financed mortgages for at least seven years if they default when they can afford to pay. (You'll have to wait three to five years after an involuntary foreclosure and two to four years after a short sale.) Defaulting also torpedoes your credit score -- at least temporarily. You can expect a 100- to 150-point drop for the foreclosure and extra points subtracted for late payments. A foreclosure can stay on your credit report for up to seven years. But if a default is your only blemish, then you might revive your credit score in as little as two years. Horton says he has seen his credit score drop from 750 to 530 since he defaulted.
Not so fast. Depending on where you live, banks can also pursue a deficiency judgment -- that is, they can come after you for the difference if your house is sold in foreclosure for less than the loan amount. About one-third of states prohibit or limit banks' suing borrowers who walk away. These are known as nonrecourse states. Unfortunately for Horton, Florida isn't one of them. He owes $140,000 on his condo, which he estimates is worth $50,000. And the home he purchased for $255,000 three years ago was recently appraised for $154,000. He is setting money aside for a settlement with the bank once his foreclosures are final. (Foreclosure laws vary widely by state; check out your state's laws at www.foreclosurelaw.org .)
Banks have rarely sought deficiency judgments. The risk of a legal action is greater for borrowers who strategically default because they have more money to pay judgments. Yet only five out of more than 5,000 YouWalkAway clients have received judgments, Maddux says. Many others who live in states that allow judgments settle for 20 cents to 30 cents on the dollar. "You are more likely to be hit by a car than a deficiency judgment if you default," Maddux says.
Banks have been reluctant to sue because it is difficult for lenders to pursue a judgment without spending a lot of time and money in legal fees, according to a recent Deutsche Bank study on strategic defaults. That may change once the economy fully recovers. In many states, a bank can sue to recoup its shortfall four to five years after a foreclosure.
Regardless, Horton is at peace with his default. Once the bank seizes his home, he may rent a house in his neighborhood for half the cost of his mortgage or travel the world with his girlfriend. "But I won't buy another house anytime soon," he says.