Today we bring you an interview with Steve Waldman of Interfluidity. I decided to focus the interview around strategic default and the ever-expanding role of the government in the housing market.

Not the most stimulating headline, I admit, but it’s a topic that deserves some bandwith. Let’s be honest: who out there even knows what a HUD 203(k) Mortgage is? Who’s first instinct (I’m guilty) was that it is an abstruse program that brings together 401K retirement accounts with mortgage financing? That’s what I thought.

Let’s get serious for a moment. A 203(k) is a HUD program that provides mortgage loans for the purchase of so-called “fixer-upper” properties. According to HUD,  203(k) mortgages serve a very important function because, “The purchase of a house that needs repair is often a catch-22 situation, because the bank won’t lend the money to buy the house until the repairs are complete, and the repairs can’t be done until the house has been purchased.”

Towards that end, the 203(k) allows the borrower to roll all of the costs of renovation into the mortgage. While these costs are theoretically uncapped, they must be estimated ahead of time. Further, it must be confirmed by an appraiser that the value of the home will increase at lease by these costs upon the work’s completion. In this way, those that might have otherwise been discouraged from buying dilapidated properties have an inexpensive source of financing (only 3.5% down, consistent with the FHA’s other mortgages).

There is also a new Streamlined 203(k) “Limited Repair Program, that permits homebuyers to finance an additional $35,000 into their mortgage to improve or upgrade their home before move-in. With this new product, homebuyers can quickly and easily tap into cash to pay for property repairs or improvements, such as those identified by a home inspector or FHA appraiser.”

The costs of these repairs, along with a “contingency reserve” of 10-20%, origination fees, and of course the purchase price of the property, are all rolled into the mortgage. Since it’s assumed that many of these properties won’t be of inhabitable condition until after the repairs are completed, the borrower also has the option of rolling 6 months of pre-payments (PITI) into the mortgage as well. Upon closing of the mortgage, the repair costs are deposited into an escrow. Withdrawing these funds can be tricky, however.

While FHA loans are effectively guaranteed by the government, they are originated and administered by private lenders. As one couple’s story illustrates, dealing with one’s lender is not always straightforward when it comes to the 203(k):

“As the contractors were hungry for work, we got started improving the property right away,” she said. “We had been told by our mortgage broker that we could expect the first draw against our $35,000 escrow 15 days after closing.”

As time passed, however, “we heard nothing from Bank of America, other then where to send our first mortgage payment,” she said.

For three months, the couple paid their mortgage, yet received no check for the work done so the contractors could be paid.

To pay for the work, “we have had to empty our savings and run up our credit cards,” she said. “We finally asked them to stop until we can find resolution with Bank of America.”

Unfortunately, borrowers who get the run-around from their lenders unfortunately don’t have much recourse, and can’t expect any help from the government. The best advice, then, is to make sure that the escrow is available to you start shelling out money for repairs. In fact, the raison d’etre of the 203(k) is to prevent the borrower from having to pay for repairs out of his own pocket. In hindsight, this couple would have been wise to heed this advice.

You’re mortgage is underwater. What do you do?

A few years ago, this would have been a fringe question for a fringe audience. Nowadays, though, 25% of all residential mortgages are underwater. In states like Nevada and Florida – two of the epicenters of the housing bubble and subsequent bust – more than half of borrowers owe more on their mortgages than their homes are worth. In other words, for a growing portion of homeowners, this question is of foremost importance.

For argument’s sake, let’s assume that you have already discussed a loan modification with your lender, and you have been either rejected or presented with an inadequate offer. As a result, you have made the decision to part with your home. [Admittedly, this is a weighty decision]. Should you sell your home at a loss, or simply walk away from your mortgage and allow your lender to deal with the fallout?

The first option is known as a “short-sale,” since the proceeds from the sale of your home wouldn’t be enough to cover the balance of your underwater mortgage. Accordingly, a short sale (or its first cousin, the deed in lieu of foreclosure) first requires the approval of the lender, because it is tantamount to writing off part of the mortgage as a loss. Still, many lenders are amenable to this possibility, because it is often less complicated – and hence, less expensive – than outright foreclosure. You will also need to confer with any junior-lien lenders as well as the mortgage insurance company, if applicable. After receiving an offer on your home, this must then be submitted to the lender (via its loss mitigation department) for final approval.

Here are a few additional things to keep in mind: Minimizing the transaction costs of the sale (by hiring an expensive real estate agent, for example) will go a long way towards convincing the lender that the deal is worthwhile. Next, while a short-sale is less painful than a foreclosure, there will still be some inevitable damage to your credit. In addition, you might be expected to pay taxes on the portion of your mortgage that was forgiven by the bank. Finally, be advised that short sales typically take longer to complete than normal sales, as lenders will often spend a long time deliberating over whether to approve the deal.

If your house has depreciated too much in value, and/or your lender is not willing to approve a short-sale, then a strategic default might be your last option. So-called as to distinguish it from a “conventional” foreclosure, a strategic default is a voluntary decision to stop making mortgage payments despite the capacity to do so. While choosing foreclosure might strike some as oxymoronic, it turns out that for many, it is actually a perfectly rational choice. Simply, the negative impact on one’s credit score and the possibility of a deficiency judgment, pales for some when weighed against the prospect of spending the rest of one’s lifetime paying off a mortgage that is well underwater.

That’s because while foreclosure technically remains on one’s credit report for 7-10 years, it can become functionally irrelevant in the eyes of lenders in half that time. In addition, deficiency judgments (in which the lender sues to collect the difference between the value of the property at the time of foreclosure and the amount owed under the mortgage) are illegal in many states, and rare in the rest. That being the case, the only remaining consideration is the moral one- deliberately breaking a contract that you have the ability to honor. While there are strong arguments to be made for both sides, I don’t think this is an appropriate forum to explore that dimension, however. Let your conscience be your guide.