Walking Away: The New Calculus

If the statistics are to be believed: “strategic default” – the act of voluntarily walking away from one’s mortgage – is now becoming quite fashionable. According to the latest estimates, more than 30% of foreclosures are strategic defaults, compared to 20% in 2009. However, the calculus of “strategic default” is changing, such that you need to think twice before jettisoning your mortgage.

The debate surrounding strategic default was ignited by Brent White, a Law Professor at the University of Arizona, who suggested that breaking one’s mortgage contract was a choice like any other, and that some borrowers were acting against their best interests by continuing to pay their mortgages. White urged such borrowers to mail their keys back to their respective lender, and continue living – rent-free – in their homes until they were forcefully evicted through foreclosure.

According to White and other proponents of walking away, the only down-side of such a decision is a negative hit to your credit score. To be sure, you can expect that foreclosure will cause your FICO score to decline by 100 – 400 points, which will make securing any kind of loan in the immediate future quite difficult, to say the least. Thanks to a 2007 law enacted by Congress, you are not responsible for paying tax on a canceled mortgage, which otherwise would be treated as forgiven debt and taxed accordingly.

However, this is not the whole story. There are 11 states that have so-called non-recourse laws, which prevent lenders from laying claim to borrower assets if the proceeds from foreclosure are insufficient to repay the mortgage: Alaska, Arizona, California, Iowa, Minnesota, Montana, North Carolina, North Dakota, Oregon, Washington, and Wisconsin. That means that there are 39 states which the lender can effectively go after you for the difference, by garnishing your wages, freezing your liquid assets, or obtaining a lien on other hard assets. In addition, the lender has up to 7 years to seek such restitution, which means that you can only really escape the lender through bankruptcy.

Finally, there is the matter of securing a new place to live. Even ignoring your beaten-down credit score, the stain of credit default will prevent you from obtaining a mortgage for 5-7 years, thanks to a recent rule imposed by Fannie Mae and Freddie Mac. Buying and Bailing – in which you attempt to secure a new mortgage on a new home, before dumping your existing one – is now quite difficult, again thanks to increase vigilance by Fannie and Freddie, as well as a more stringent guidelines for mortgage lending. The only realistic alternative, then, is to rent….that is if you can find a landlord who is amenable to your financial situation.

In short, I would like to clarify my position regarding strategic default: you should only do so if you live in one of the 11 states listed above and if you are sure about your ability to secure a new place to live following foreclosure. You are also advised to speak to an attorney in order to fully understand your liability. Of course, if all things considered, it’s in your best interest to strategically default, then by all means, go right ahead.