Wanting to downsize their lives as they headed toward retirement, they bought a new house in Mesa, Arizona,
before they sold the old one, also in Mesa. Their previous home had
been appraised at nearly $400,000 at the height of the market, but as
the housing crisis ravaged Arizona, they were told they'd be lucky to
get $200,000 for it.
They were carrying a loan of $260,000 on
their original home alone, meaning they were well 'underwater,' owing
much more than it was worth. Combined with the mortgage on the new
house, their housing payments had become an "anchor around our necks,"
she says, threatening to gobble up all their retirement savings and
leave them with nothing.
The couple made a difficult call: They would do a 'strategic default,'
and simply stop paying the old mortgage. "We really had to wrestle with
it," said Perkins, 60. "We had worked all of our lives to build good
strong credit, and we're proud people. But it came down to, 'Can we keep
doing this?' We had to say 'No.'"
As the housing bust drags on,
many homeowners are thinking like Perkins. Almost 11 million homes are
now underwater, says financial information provider CoreLogic. Around
3.5 million homeowners are behind in their payments and another 1.5
million homes are already in the foreclosure process, according to
online marketplace RealtyTrac.
As banks start to work through
their backlog of distressed properties, the New York Federal Reserve
estimates that 3.6 million foreclosures will take place during the next
couple of years.
So, the question is: Does it make sense to keep
paying a massive mortgage, knowing that it might be decades before a
home regains its prior value? Or is that akin to - as columnist James
Surowiecki recently wrote in the New Yorker - "setting a pile of money
on fire every month"?
"I constantly get the saddest e-mails from
people saying, 'I've exhausted all my life savings, my retirement is
gone, and now I have to default,'" said Jon Maddux, CEO of
YouWalkAway.com,
a foreclosure agency that helps clients with strategic default
(and charges a fee for it). "But if they had seen the writing on the
wall a couple of years earlier, stopped paying the mortgage and stayed
in the home throughout the whole process, they would be in a much better
financial position."
Moral Quandary
There's
a moral component to that decision, of course. People naturally feel
embarrassed about breaking a contract and not paying their bills; no one
wants to be branded a deadbeat. But remember that companies default on
their obligations when it makes financial sense for them to do so, via
the bankruptcy process. Even the Mortgage Bankers Association itself, in a flourish of irony, arranged for a short sale of its Washington headquarters.
It's not personal; it's business. So think of strategic default as a business decision, and do a cold-eyed cost-benefit analysis of whether it makes sense for you, advises Carl Archer, an attorney with Maselli Warren in Princeton, New Jersey.
"People
think it reflects on their integrity, and say 'I wasn't raised this
way,'" said Archer. "But the more businesslike attitude is to say that
there's a contract, there are penalties for violating that contract, and
sometimes it just makes financial sense to break it."
The
penalties largely revolve around your credit record, which admittedly
gets blown up in the near-term. For a few years you can likely forget
about qualifying for a mortgage or a car loan. When lenders are ready to
take a chance on you again, you'll have to pay for the privilege, with
stiff interest rates due to your default history.
What Happens to Scores
Charlotte Perkins
watched her credit score go from a pristine 800 to 685, dropping every
time she missed a payment. Credit-scoring firm FICO estimates that
someone with a 680 score would see that number sink between 85-100
points after a strategic default, and someone with 780 could crater 140-160 points.
Not
desirable, of course, but not the end of the world either. For Perkins,
for instance, she already had a loan on her Ford Escape, and the
mortgage on her new house, before she even started the default process.
She hasn't seen any changes on her credit cards since, in terms of
limits or interest rates.
Now that the previous home was
auctioned off in December, she can start slowly rebuilding her credit, a
process that should take about seven years.
Strategic default
isn't a decision to be taken lightly, of course. If everyone did it,
the housing market -- and the banks -- would be in much worse shape than
they already are.
The following are some of the issues to keep in mind:
1. Look to it as a last resort, not a first option.
Your financial troubles could be alleviated with a simple refinancing,
especially since 30-year mortgage rates are near record lows of below 4
percent. If the banks are hesitant to rework your loan, look into the
number of government programs designed to keep you in your home, which
can be researched at MakingHomeAffordable.gov.
2. Location, location, location.
Each state has its own rules and regulations regarding foreclosures,
which affect both the length of the process and what you could be liable
for in the end. In so-called 'non-recourse' states like Arizona,
California and Texas, a lender cannot come after you for any deficiency
(for instance, if your mortgage was $300,000 and they're only able to
sell the property for $200,000). In other states they can pursue the
difference, in theory - which is why some homeowners opt to file for
bankruptcy, to free themselves from those potential obligations as well.
3. Use the interim to save like a demon.
If you're in a state like New York or Florida, which require a judicial
review of every foreclosure, it might be a couple of years before you
actually have to pack up. In the meantime, be extremely disciplined
about stockpiling cash. That will help you with a down payment for a
rental, to pay for a car in cash if you need to, or to clear up other
debts you might have. "Save money as if you were still paying the
mortgage," says Archer. "If you don't, then you'll run out of both time
and money, and then you'll be in a real tough spot."
4. Know the tax implications.
Historically, if you have a debt that's forgiven, the canceled amount
is considered taxable by the IRS. In the wake of the housing bust,
though, the Mortgage Forgiveness Debt Relief Act was drafted to spare
you those taxes. That legislation expires at the end of 2012, though -
so if it's not extended, you could potentially face a tax bill for the
difference.
5. Talk to a professional. A
bankruptcy or real-estate attorney can help you through a very tricky
process. The National Association of Consumer Bankruptcy Attorneys, for
instance, has a searchable database of lawyers at www.nacba.org.
"Strategic
default is not an easy decision, and there's a cost either way," said
Gerri Detweiler, director of consumer education for Credit.com. "Would
you rather be $200,000 underwater, or would you rather have seven years
of damage to your credit report? It depends whether you're finally at
the point where enough is enough."