Short Sale or Strategic Default: What’s the Best Choice?

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.