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“Strategic foreclosure” is a term you’re likely to hear a lot about in the coming months. If reports are true that housing prices will continue to fall throughout the year, chances are homeowners will elect to walk away from their underwater mortgage even if they have enough money to pay loan installments.
Strategic foreclosure has been a hot topic of conversation within the real estate networks I participate in. It’s a controversial subject and responsible for plenty of forum flame wars. Some investors feel it is a brilliant financial strategy. Others think it is financial suicide, immoral, and unethical.
Until recently, strategic default has been used primarily by homeowners and investors with stellar credit who are fully capable of paying their mortgage. Instead of continuing to pay on real estate that is no longer worth the paper it’s written on they choose to stop making payments and force the bank to provide options. Banks aren’t willing to work with homeowners who can afford their payments. You can’t just call up the bank and say, “Hey, my house is worth $50,000 less than I owe you. Will you write that off and reduce my payments?” Instead, you have to stop paying before the bank will negotiate.
Many of the real estate investors I know are using this strategy to force banks into short sales, deed in lieu of foreclosure, or mortgage principal reduction. This can be a risky proposition, so those who elect to go down this path need to hope for the best and prepare for the worst.
While it may seem logical to voluntarily default on an underwater mortgage, take time to calculate the true costs. If it works and the bank offers a foreclosure prevention strategy that either allows you to short sale, return it using deed in lieu, or reduce the principal balance it might be a smart move. However, if the bank calls your bluff and commences with foreclosure it will tarnish your credit for quite some time. Anyone who has engaged in credit repair will tell you it’s a painfully slow process to boost FICO scores. Not only will you be unable to buy a house for at least a few years, you’ll pay through the nose when you do qualify for credit.
Lenders assess interest rates based on credit scores. The lower the score, the higher the interest. FICO scores can plummet by 100 points or more once foreclosure is reported to credit bureaus. Chances are insurance premiums will rise. Interest rates on credit cards will go up and credit limits reduced. It might be challenging to find a landlord willing to rent unless you pay first, last, and security deposit.
Subprime lending is a major player in the foreclosure fiasco, so banks have tightened lending criteria. In fact, a mortgage standards reform proposal is in the works that will make qualifying for a home loan even more difficult in the near future. While reduced FICO scores might not seem like an overwhelming challenge, they can become a mountain if your mortgage lender holds you responsible for monetary deficiencies. Most banks require homeowners to pay the difference between their loan balance and sale price. If you owe $200,000 and the house sells at auction for $170,000 you might be holding the bag for thirty grand.
When banks issue deficiency judgments they can take action to collect the debt. Usually this in the form of garnished wages. At minimum, the judgment remains on credit reports for up to 10 years after the debt is paid. Judgments can reduce credit scores that won’t rebound until removed.
A final consideration of strategic default is that of morals. Even when it makes perfect sense to go forward, most homeowners feel an ethical obligation to make good on their promise. They understood when they bought the property it carried risk. So, they are willing to ride it out and hope the market eventually turns around.
Only you can decide if strategic foreclosure is in your best interest. It may provide the mortgage relief required, but not without financial consequences. If you can afford the payments, you’ll have to search your moral database to decide if you can walk away guilt-free.
More from this contributor:
Is the Las Vegas Real Estate Market the Greatest Sin of All?
Improper Foreclosure Could Cripple Major Banks
ForeclosureGate: The Fed Investigates Wrongful Foreclosure