Should you walk away from your mortgage? It's a question many homeowners as pondering, as falling home values have left as many as one-third of those with mortgages "underwater," owing more than their property is worth.
In that situation, simply deciding to stop paying your mortgage and turn the keys back over to the bank can seem like a good economic decision. Why continue to make payments on a $400,000 loan for a house that's only worth $250,000? At the same time, many argue that homeowners have a strong moral obligation to make good on their debt, regardless of how much the home is now worth.
It's not an easy question and there are no simple answers. A "strategic default" or "voluntary foreclosure," as it's known when a homeowner simply quits making payments on a mortgage that exceeds the value of a home, can make good financial sense. But there are pitfalls to be aware of as well.
As many as one-third "underwater"
Current estimates of the number of homeowners with "negative equity" in their homes range from 10-16 million - as many as one-third of all outstanding home mortgages in the U.S. Home values nationwide have fallen an average of 25 percent over the past three years, according to a leading survey by Standard & Poor's/Case-Shiller, with some areas, such as parts of Florida, California and Arizona, down by as much as 50 percent.
The further "underwater" a homeowner is, the greater the incentive to simply cut their losses and walk away from the mortgage. Separate reports from Citigroup and the data reporting company Experian estimate than one-fifth of all mortgage defaults are voluntary. A recent study by the University of Chicago and Northwestern University puts the figure as high as one in four.
The case for walking away
According to Brent White, a law professor at the University of Arizona, more homeowners should be walking away from their mortgages. In a newly published paper, "Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis," he argues that many homeowners could save hundreds of thousands of dollars through strategic defaults. He also contends that the downside of foreclosure are not nearly as severe as the banking industry makes them out to be and that a homeowner's credit can actually recover in as little as three years.
White's critics say it actually takes more like five years for one's credit to significantly recover from a foreclosure and note that it takes seven years for it to disappear completely. They also note that a voluntary foreclosure means breaking a legally binding contract, although admitting the only penalties are financial, and not criminal.
So what to do? It's worth noting that if you do walk away from your mortgage, a default and foreclosure will put a major dent in your credit. You may find it impossible to buy a new car if you need one. Your credit cards could be cancelled or, at the very least, see their rates go through the ceiling. If hit with unexpected expenses - such as car repairs, medical bills or the like - you may not be able to obtain the money to pay for them.
Renting a new home may be difficult
A strategic default also assumes that you'll be able to save significant money by renting instead of making a mortgage payment every month. However, be aware that with a voluntary foreclosure on your record, you may have great difficulty obtaining a lease on the type of home you'd like to have. Many landlords, particularly those with more upscale properties, will refuse to rent to someone who just walked away from a major debt. You may find that any rental property you are able to obtain will represent a significant step down in terms of your living standard and things like neighborhoods, schools and the like.
Even if you do give your home up for foreclosure, that may not be the end of it. In some states, a lender is entitled to seek collection of any unpaid balance that remains after the property was sold in foreclosure. So if you owed $225,000, the property sold for $125,000, the bank could still come after you for the remaining $100,000, particularly if you have assets remaining after the foreclosure. This doesn't happen often - the cost of recovery in court tends to deter most lenders - but it is still a possibility to consider.
There's also the question of whether you would feel comfortable walking away from a mortgage you could still make the payments on, even if it made economic sense. Some argue that there's a double standard for private homeowners compared to how business operates. They note that an investor or corporation would simply regard it as good business to simply write off several mortgaged properties whose value had sunk below the mortgage balance, but homeowners are expected to keep paying their note no matter what. However, many people do feel personally bound by a written contract and that making good on their financial obligation is the only ethical thing to do.
There's also the question of what would happen if large numbers of people began voluntarily defaulting on their mortgages. Those who say strategic defaults are unethical tend to argue that such a scenario would send the housing market crashing back down again and possibly kick off an economic depression. Others, however, contend that the prospect of large numbers of voluntary defaults would motivate lenders to become more flexible on loan modifications and other foreclosure prevention efforts, including writing down the principal on homes that have lost value.
In the end, a voluntary foreclosure is not illegal - there are no criminal penalties, you can't go to jail for it, though you can be held liable for the costs incurred by the lender. But it's still a desperate, last-ditch strategy. Even if home prices do take many years to recover, history has shown that they do recover eventually, and most markets are not nearly as far down as those in places like Florida and California. For most homeowners, a better strategy is likely to try to reduce your costs by seeking a refinanced mortgage or loan modification and hang on until better times arrive.