Strategic Default: The Consequences of ‘Walking Away’

Are you considering halting payments on your mortgage? If your mortgage debt is higher than your home value, you might be. 

Over the years, house prices and home values have gone up and down. When house prices go down, more people have mortgage balances that exceed the value of their homes. They start considering mortgage default even when they have the money to make regular payments because doing so might save them money in the long run. This approach is called strategic default, or strategic foreclosure.

A strategic mortgage default has serious consequences, and might not be worth it, even if the housing market is bad, so this strategy should not be embraced lightly.

Understanding Strategic Default

Strategic default occurs when a borrower purposefully stops making payments on a loan, even though they can afford to remain current. Once they stop making payments, they default on the loan. Strategic defaults are most common with residential and commercial real estate mortgages. This deliberate approach differs from most defaults that occur due to financial difficulty. Strategic default is purposeful and does not generally occur out of necessity. 

Strategically default is also sometimes called walking away. In the context of real estate, walking away from a property means the borrower has abandoned the property and stopped making monthly mortgage payments. The borrower may also send “jingle mail”, which involves mailing keys to the property back to the lender.

When a borrower voluntarily stops making payments or walks away from the property, the lender will likely start the foreclosure process. 

Why Would a Borrower Strategically Default?

Generally, borrowers strategically default when a property is significantly underwater. When a property is “underwater,” it is worth less than what the borrower owes on the mortgage, leaving no home equity for the borrower. The deficiency between the mortgage and the value is called negative equity. Underwater mortgages are most common when home prices drop.

When a property is underwater, borrowers often consider two options: either continue to make payments in hopes that the market will recover and the property value will increase, or stop making payments assuming that the home price won’t increase. When a borrower determines strategic default to be a better financial decision than continuing to pay their mortgage, they are attempting to cut their losses.

Things To Consider Before "Walking Away"

Walking away from a debt has many significant consequences. Although there are some instances wherein strategic default is worth these consequences, these instances are rare. Regardless of why you’re walking away, any default will always cause both immediate and long-term damage to your finances. So, you’ll need to think carefully before committing to strategic default as a plan of action.

Below are a few consequences to consider before deciding whether to walk away from your mortgage debt:

Deficiency Judgments

If a home is sold in a foreclosure sale, but the sale proceeds are not enough to cover the full amount owed, the former homeowner could still be liable for the remaining difference, called the deficiency amount. 

If there is a deficiency amount, then the lender could sue the homeowner and get a deficiency judgment from the court. With a deficiency judgment, the lender will be able to take collection actions against the homeowner to get the deficiency amount back. Collection actions may include wage garnishment, bank account levies, liens, etc.

For example, if you were to walk away from a mortgage when you still owed $200,000 and the home was sold at the foreclosure for $150,000, then the deficiency amount would be $50,000. Unless you agree to repay the $50,000, the lender would pursue that debt by obtaining a deficiency judgment and then taking collection actions against you. 

Recourse Loans vs. Non-Recourse Loans

A recourse loan is a loan that allows a lender to go after the borrower's other assets (beyond the collateral used to secure the debt) for a deficiency amount if the borrower defaults on the loan. 

A non-recourse loan is a loan that only allows the lender to seize the collateral offered by the borrower when the loan was approved. Collateral, or collateral assets, are assets that a borrower offers to secure a loan. This collateral must be identified in the loan contract.

For example, a borrower may offer a collectible car as collateral for their mortgage loan. If the borrower later defaults and there’s a deficiency, the lender’s ability to seize specific assets will depend on whether the loan was a recourse loan or a non-recourse loan. 

Although most states allow recourse home loans, 12 states have now banned them: Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington. In the states that have banned recourse loans, all home loans are non-recourse loans. 

Significant Credit Damage

Strategic default and a subsequent foreclosure will have the same effect on your credit report and credit score (or credit rating) as a regular default and foreclosure. Usually, default and foreclosure will drop your credit score by 100 to 150-points, or more.

Bad Credit Can Prevent You From Getting Another Mortgage

If you walk away from a debt, especially a mortgage, you could have difficulty getting another home mortgage for quite a while because you will no longer have good credit. If you can secure a new mortgage, you may only be eligible for subprime loans.

Fannie Mae, also known as the Federal National Mortgage Association, has even stated that people who strategically default on a mortgage loan will NOT be eligible for a mortgage-backed by Fannie Mae for at least seven years from the date of foreclosure. Fannie Mae has also stated that if a borrower strategically defaults on a mortgage, it will take legal action to recover any remaining outstanding debt in states that allow deficiency judgments.

Bad Credit Can Prevent You From Getting Other Loans and Credit Cards 

Bad credit caused by a strategic default can prevent you from being approved for other loans or credit cards for a number of years. This includes car loans, personal loans, credit cards, etc. Even if you are approved, you likely won’t be eligible for favorable terms and lenders will only extend you high interest rates.

Quality of Life Considerations

Strategic default can also impact your quality of life and employment. For example, many employers routinely run credit checks on job applicants. Since many employers consider your credit score as a part of your job application, the damage to your credit report could negatively impact your ability to get hired.

Damage to your credit can also prevent you from getting an apartment. As a part of the lease application process, landlords usually pull your credit report. In a competitive rental market, someone with a higher credit score might get the apartment over you.

Some Alternatives to Strategic Default

Before deciding whether you’d like to strategically default on a mortgage loan, consider the options noted below. You may find one of them to be a better alternative to default:

Short Sale

In a short sale, instead of foreclosure, the homeowner sells the home for less than the total balance of the outstanding debt. The proceeds of sale then go to the lender to pay the mortgage debt. Short sales must be approved by the lender. Also, the lender may still sue to recover the deficiency unless they agree to forgive it. Note that if the lender forgives the deficiency amount, the IRS may consider the forgiven amount as income. As a part of your income, the forgiven deficiency will be taxed. 

Also, the deficiency amount may be limited by state law to the difference between what the home sold for and the home's fair market value. These state limitations incentivise mortgage lenders to forgive deficiencies because the amount allowed is usually much less than the actual amount owed.

Deed in Lieu of Foreclosure

With a deed in lieu of foreclosure, the borrower gives the deed to the property to the lender. If the lender agrees to this option, they accept the deed instead of foreclosing on the mortgage. Just as with a short sale, the borrower could face a deficiency judgment if the lender decides to pursue a deficiency balance.

Loan Modification

A loan modification occurs when a borrower negotiates new mortgage loan terms with their lender. Modifications usually lead to lower monthly payments. Loan modifications may also include a lower interest rate or an extended loan term. Loan modifications are similar to a loan refinance. However, refinancing involves replacing one loan with another. Loan modifications involve changes made to an existing loan.

Homeowners who would like to modify their loan need to inquire as to whether their lender or loan servicer is willing to negotiate new terms or other temporary adjustments, like a loan forbearance. 

HUD-Approved Housing Counselor

If you need help with your mortgage, or you’re not sure what to do next, contact a mortgage relief program for guidance. Through a relief program, you can speak with a HUD-approved housing counselor who can explain options that might be available to make your mortgage payments more affordable so that you can save your home.

Let's Summarize...

A strategic default occurs when a borrower decides to stop making payments on a loan, even though they may be financially able to continue making payments. Borrowers usually decide to default on a mortgage when their property is underwater, meaning that it’s worth less than what the borrower owes on the mortgage. Borrowers make the financial decision to cut their losses and walk away from the property and their mortgage debt through strategic default.

Although strategic default is an option, it will result in significant consequences. Before deciding whether to walk away, speak to an experienced local attorney and/or a certified credit counselor about the advantages and disadvantages of this approach.