Strategic Default (part 3) – Even when it’s OK, it might not be right
Viewpoint 08/04/10
Strategic Defaults (part 3) – Even when it’s OK, it might not be right
“I love the man that can smile in trouble, that can gather strength from distress, and grow brave by reflection.” – Thomas Paine
Before we get started with today’s Viewpoint, let’s do a quick recap of parts 1 and 2.
In Part 1 we touched on 3 main points:
1. The banks not only helped cause this mess, but they’ve acted with duplicity in response to it – they don’t want homeowners to change the terms of their deals, while at the same time the banks are changing terms of their own deals.
2. There’s nothing illegal about it – both parties signed a contract, and the contract spells out what to do in case of default.
3. We would still be OK if everybody did it.
In Part 2 we showed how the banks & media are grossly over-stating the numbers of Strategic Defaults. There are 4 different financial circumstances which lead to default:
1. Forced default – homeowners who have run out of money.
2. Time Shifters – homeowners who will eventually become Forced to default, but who default early in order to save some of their money.
3. Savings Shifters – homeowners who can still pay their mortgage, but can only do so by raiding their savings or their future savings (such as not contributing to their 401k).
4. Strategic Default – homeowners who have not been affected by the current economic environment, but who choose to default as a way to get rid of an underperforming asset.
The banks are reporting many of the people from #1, and all of the people from #2 and #3, as Strategic Defaults (#4).
Based on Parts 1 and 2 I’ve laid out the viewpoint that each family needs to do what’s best for them, and if a tactical or strategic default is the best option, so be it. Nobody should feel they ‘owe it to the banks’ to continue paying a mortgage they can’t afford. In fact, in most of these cases, the homeowner’s situation has changed enough that the bank wouldn’t make them that same loan today!
Even when it’s OK, it might not be right.
Today I’m going to share an opposing Viewpoint – not that I’ve changed my mind and am now siding with the banks, but that in many cases walking away from your mortgage (Strategically Defaulting) is NOT in your best interest.
Anyone considering a strategic default will want to weigh the pros and cons of their decision – financially, socially, and emotionally – with the goal of ending up in a better position than where they started.
Let’s take a look at these three components in detail to identify the pros and cons:
Financial Implications of Strategic Default
Many times financial decisions are easy – what’s the difference in costs, and in revenue generated, between two or more different options? When considering a strategic default, however, the choices aren’t as clear. You’ll want to ask a multitude of questions to yourself, and the answers to many of them are dependent upon future events completely outside your control.
Here is a short-list of questions which will have a financial impact on your decision:
1. How long did you intend to keep this house?
2. Where will you live when you move out of this house?
3. How long will it take to rebuild your credit score?
4. How long will it take to save a down payment to buy your next house?
5. What might happen, outside of your control, which could make your decision better or worse?
How Long – What’s your time frame?
If you have a fixed-rate, fully-amortized loan and can afford to make the monthly payment, your home will be paid for – free and clear – at some point in the future. The loan balance will go down every single month. The home’s value should begin to rise at some point. (but even if it never does, and 25 years from now it’s worth the same as it is today, you’ll still have equity in a property and no mortgage payment!)
Consider a hypothetical example of a person who bought at the peak in 2005. He paid $375,000, made a 20% down payment, and financed the rest at 6.0% over 30 years. Today that home is likely worth about $200,000. Let’s assume the home appreciates very slowly from here, at 2.5% per year.
The negative equity inversion is obvious. It started in 2008 and will continue until 2017. That’s a long time to be up-side-down on your largest asset! However, where we’re sitting today is the worst things get (in this example); the gap closes a little bit each year. Eventually the home is worth about what the buyer paid for it and the mortgage is paid in full.
The longer your timeline, the more staying in your current house makes sense.
Where will you live?
If you have the means to buy your next house today, it’s hard to argue against the strategic default. You can pick up a similar house at about 60% your current home’s price, which would in turn reduce your mortgage payment by a similar percentage. On top of that, you’ll also get the lowest interest rates in 3 generations! Take a step sideways, move into a similar home in a similar neighborhood, enjoy a lower monthly payment for the next 20-30 years, let your credit recover over the next few years, and then let the bank take the hit on your former house… Sounds pretty good.
The banks are on to your plan, though. They call this scenario “Buy and Bail”, and they are extremely conservative right now about making loans to people who are keeping their existing house – the scenario I described above won’t have a shot at getting approved. So I hope you have access to some private money on the cheap – maybe a family trust fund?
The rest of us would be stuck with renting a home while everything else plays out. Could be good, could be bad – depends on what’s available in the area you want to live, and for how much.
Rebuilding your Credit
First thing you have to do is wait until the foreclosure is completed, which is routinely taking more than a year and I’ve heard of it taking 2 and 3 years. Your credit is going to be “blown up” on the date the foreclosure records, and you get to start rebuilding it from there.
The rebuilding process is going to be different for everybody. I’m assuming, since we’re talking about people who are strategically defaulting, the rest of their credit is good and will remain intact. These folks will probably be able to rebuild their credit faster than those who are forced to default due to lack of income &/or increased expenses.
Saving for a down payment
Can you save money while you live in your house without paying your mortgage?
In my example above (with the chart), the monthly mortgage payment is about $1,800, not including property taxes and homeowner’s insurance. If it takes the bank 18 months to take the home back and you divert all these non-payments into a savings account, you’ll have saved $32,400!
Is that enough for your the downpayment on your next home? Depends on what you buy, where you buy, and what the lending environment is like when you buy.
Now consider the downside risk – what if your home is one of the homes the bank processes fairly quickly? You’ll have to start saving for a down payment while you’re making a rent payment (which might not be too much smaller than your former mortgage payment!)
External Factors
The mortgage environment is in a state of flux right now; guidelines are changing almost every month.
Right now FHA will approve applicants with 2-3 year old foreclosures under certain circumstances, but there’s talk of FHA becoming more restrictive.
FNMA recently increased their penalties for strategic default to include a 7-year lockout period. (This is a disaster waiting to happen, as many people who are forced to default are being counted as strategic by the banks and reporting agencies. But that’s a topic for a different day.)
There are others in the industry (count me among them) who believe the banks are motivated only by money, and a few years from now, when there are millions of former homeowners ready to buy homes again (and start making mortgage payments with interest), the banks will be lining up to make these loans. And if FNMA or some other bureaucratic red tape gets in the way, other institutions such as credit unions and community banks will lead the way.
On top of the mortgage itself, what about other parts of your life which might make decisions based on your credit? Employers, Insurance Companies, anyone else who might extend you credit (auto dealers, credit cards, personal credit lines).. Any change you face in your life might become more expensive, or not even possible, because of your credit score.
Social Implications of Strategic Default
Remember the old “What would your mother think?” test? Or the “How would you feel if your story landed on the front page of the newspaper?” test?
Are you the only one in your social group contemplating a strategic default, and you find yourself hiding that fact or making excuses to your friends and family, you should probably give a lot of thought to what happens when people find out (as they invariably will at some point, since we all live on some version of Wisteria Lane)
I’d put a big mark in the “Con” section if you risk social ridicule or future job advancement because of your decision.
Emotional Implications of Strategic Default
The emotional (inward) effects can be even larger than the social (outward) effects. I’ve spoken with scores of people who have gone through a foreclosure or short sale; not one of them thought it was easy. In fact, I hear a lot of similarities in their stories..
“It can be depressing – I have to make a conscious decision everyday to be positive and look toward the future.”
“I moved out of a house I loved and planned to be in for the rest of my life, and into a house that I don’t really like.”
“Watching the kids pack up their stuff…”, or the variant “I cried like a baby when I had to take the kids’ stuff off the walls.”
“It was tense – we fought a lot during the process. Even though we both agreed it was the right thing to do, it was just very stressful.”
Unfortunately going through a foreclosure isn’t a quick and easy process; it has been routinely taking over a year from start to finish.
Justin McHood is a local mortgage professional who guest authors on my broker’s blog from time to time. Here is a perfect, first-hand account of the emotional stress involved: Thinking About Short Selling Your House: What No One Will Tell You.
Part 3 Conclusion
Those considering a Strategic Default as a way to rid themselves of negative equity need to consider a wide range of factors, including the financial, social, and emotional implications. Once all factors are considered, many people who consider a strategic default will find it’s not their best option.
However, if you’ve considered all angles and all possibilities, and you’re convinced it’s the best option for you and your family… Go for it.
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Until next Viewpoint,
Your hoping strategic defaults become a thing of the past Realtor,
Chris Butterworth
Chris & Heather, The Phoenix Agents
at Thompson’s Realty
http://thephoenixagents.com
623-570-9940
Chris Butterworth and Heather Barr are The Phoenix Agents at Thompson’s Realty. The Phoenix Agents are Realtors in the Greater Phoenix area, who have built a loyal following over the years by offering superior service levels coupled with a low-pressure approach. You can visit http://ThePhoenixAgents.com online to learn more about Chris, Heather, and the Phoenix-area real estate market. If you have real estate questions or needs, please contact us anytime; we’d love to hear from you.
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