Should I Strategically Default on my Mortgage?
Today millions of U.S. homeowners and investors are facing one of the most difficult decisions of their life – whether to default on a mortgage. For some this is their primary residence and their only real estate investment. For others it is investment properties which are no longer worth what they owe the banks. In either case, the decision brings up many considerations and often strong emotions.
My goal in this article is to help you make the right decision about whether or not to default in a strategic manner (hence the terms Strategic Default) on one or more mortgages you have. And once you have made a decision, to point you in the right direction on the steps necessary to effectively carry out your plan.
The Decision to Make a Strategic Default
This part should be easy, so let’s keep it simple. You should seriously consider default if:
- If you owe more than your property is worth, and
- You do not have cash flow from income on the property that fully covers the expenses, and
- You have a very good chance of not being held responsible for a deficiency related to the mortgage.
Simple right? Basically, if you can stop paying and get out of any further obligation to pay with minimal real economic impact, then you should probably do it! What holds people from choosing a strategic default? Two things:
- Expectation of massive personal economic impact in the form of:
- I will lose what I put into the property if I default now.
- I will have to pay more taxes if I default.
- I will be subject to legal action, lawsuits and bank collection process.
- I will ruin my credit and doom my financial future.
- I am a BAD PERSON for not paying my debts. The moral choice is discussed in this article as well as in my previous post Strategic Default is Sometimes the Moral Choice.
Let’s look at each of these carefully…
What is the real Economic Impact of Strategic Default?
I will lose a lot of money if I default now.
The economic analysis on strategic mortgage defaults is fairly straightforward. A fictional person, let’s call her Grasshopper, buys a condo in downtown Miami as an investment property and pays $300,000 for it. She finances the condo, and because she has very good credit, Grasshopper is only required to make a down payment of 5%. The market goes up and up and up and developers flood the market with new condo projects because we all know real estate never decreases in value (YEAH RIGHT). After a year, Grasshopper’s condo has appreciated in value by $50,000, so she refinances for $350,000 and puts some money in her pocket. Reality Check: The market CRASHES. Grasshopper’s condo loses 40% of its value (now worth only $210,000).
Unfortunately, Grasshopper’s scenario is all too common. From an economic perspective, she is underwater on her mortgage. Even if you account for the $50,000 that she put in her pocket after refinancing, Grasshopper is still in a negative equity position. She has a $350,000 mortgage on a condo worth only $210,000 (a deficiency of $140,000). And here is the question: “Does walking away now lose Grasshopper the $140,000?” The answer is actually – NO. Why? Because she has already lost it no matter what she does! The money is gone and holding on to the property not only will not bring it back, but is likely to bleed even more of her money away.
In this case walking away is economically the best course of action that Grasshopper can take on multiple levels, both for herself economically and for the entire market (what I am calling the “moral choice” which I will explain later).
If you’re still not clear, try on this question:
“Would you take on $350,000 of debt to buy a condo worth only $210,000?”
The answer to that question is clearly “NO!” The only thing we have changed in this example is the timing of the unfavorable debt to value ratio. This highlights a very important point that cannot be overemphasized: Real estate fluctuates in value just like any other inflationary asset! Even more important than this insight is the realization that when money is “loose,” i.e. where lending restrictions are relaxed and everyone can get a loan, real estate becomes the subject of speculation and looks just like the stock market, bubbles, drastic price swings, collapses and all!
What do you do when you are losing on a stock that you have lost faith in recovering? You cut your losses. Real Estate demands the same analysis. Strategically defaulting on a mortgage when it makes sense to do so is the right economic choice. It doesn’t make sense to knowingly pay more for something than that thing is worth, or hold on to it either.
The takeaway, however, is that people like Grasshopper are not solely to blame for the current situation, the real estate bubble and the speculation which created it have a much bigger story. And I will propose that both the Government who implemented the loose money policies and the banks and lenders who exploited them for profit should share in the consequences. You do not do anyone a favor by carrying the guilt and blame for a systematic dysfunction of which you played only a part. You do support reform when you take responsibility for your part and hold others accountable for theirs.
I will have to pay more in Taxes
There is a story out there that debt forgiveness by the lender would have huge tax consequences for the borrower. This statement is most often completely incorrect. First of all, if we are talking about a strategic default on the mortgage of a primary residence, The Mortgage Relief Act , which effects debts discharged on or after Jan 1, 2007 and before Jan. 1, 2013, generally allows taxpayers to exclude up to $2 million per married couple of mortgage debt forgiveness on their principal residence (does not include second homes or income property).
Specifically, under the exclusion, the taxpayers gross income would not include any discharge of qualified principal residence debt (Code Sec. 108 (a) (1) (e) ) If this provision applies to a taxpayer he or she should consult with their tax preparer who would need to file form 982 with the taxpayers applicable income tax return. According to The Mortgage Debt Relief Act of 2007, debt forgiven on a primary home does not generate any tax due to the IRS. However, local state tax law may differ. For this reason it is extremely important to seek advice with a qualified tax planner or attorney.
Let me point out that this is a recognition by the government that they must share some of the responsibility for this debacle. Notice that it is also time sensitive – you have only until Jan 1, 2013 to take advantage of this. And as we will discuss in more detail, timing is critical and sooner is almost always going to be far better than later.
If we are talking about investment property which is not subject to the above relief there are still many circumstances in which there will be no additional taxes due. You may have losses that offset any gain, or your CPA may be successful in arguing that there was no “economic benefit” to you. While forgiven debt may be classified as income to the borrower if the lender reported it as such, there are several EXCEPTIONS and EXCLUSIONS that may result in the non-taxability of all or part of the taxpayers income from the cancellation of that debt.
Now, all that being said, let me make a very important point. Even if you had to claim 100% of the forgiven amount as taxable income it will still be much less than paying the full amount of your underwater mortgage, plus the interest over the next however many years. This is one case where the tax tail should definitely NOT wag the decision dog!
I will get involved in numerous judgments and lawsuits.
FORECLOSURE – In a strict sense, a foreclosure is the legal process in which the homeowner loses his rights to a property due to default. It does involve the courts and a judge and may result in a forced sale of the property in a public auction, with the proceeds being applied to the mortgage debt and may incur fees and penalties.
SHORT SALE – On the other hand, in a short sale, the lender allows the borrower to sell his property for an amount that is lower than what he owes. A SHORT PAYOFF is when the bank accepts a reduced payoff from the borrow themselves and is treated the same way as a short sale.
The lender may or may not also agree to forgive any deficiency. If they do, then that is the end of it and the lender will not seek a deficiency directly or be entitled to sell that deficient obligation to a further collection agency. If the lender does not forgive the debt, he can either, a) get a court order money judgment to chase the borrower for the money or b) sell the debt to a collection party, typically for about $.10 cents on the dollar (more on what happens in this case below).
NON RECOURSE – In a considerable number of states (non-recourse states), including the ones with the biggest declines in home values, the law prevents lenders from pursuing homeowners for a deficiency judgment for their primary residence. These non-recourse states are: Alaska, Arizona, California, Connecticut, Florida, Idaho, Minnesota, North Carolina, North Dakota, Texas, Utah and Washington.
It is important to stress that these non-recourse laws may not offer any protection for deficiency judgments related to properties that are not primary residences such as rental properties or vacation homes. However, if you are in one of these states and your decision pertains to your primary residence, then the choice gets even easier as you are already guaranteed to have no hanging deficiency at all!
ONE ACTION – In several states, (one action states), the lender can only pursue one single action to recover a debt that is secured by a mortgage or lien on real property. This may work out differently for each state. In New York for example, lenders are obliged to choose between a foreclosure on the property or suing to collect the debt. One action states are California, Idaho, Montana, Nevada, New York and Utah. This is almost as good as in the non-recourse states, because most lenders will chose to foreclose on the property, thus eliminating their right to pursue you individually for any deficiency.
RECOURSE – Even in states where lenders can pursue debt deficiency (recourse states), they do it very rarely, unless they have special reasons to suspect the borrower has both sufficient and accessible resources to cover the deficiency debt. They are far more likely to sell the debt to the dreaded collection agency.
COLLECTION AGENTS – Most people are pretty terrified of these guys. The basic idea here is that these guys buy boxes of legal judgments from banks, typically for pennies on the dollar. They then pour these loans into their collection machine comprised of call centers, email blast raids and letter dumping on the debtors. They are trained in the fine art of guilt tripping and harassment and they win when they convince you to give them a check. They push fear and make threats in an effort to extract money from you by any means necessary. And while these guys have always prowled the back alleys of the legal system, their world is now getting a lot bigger! As more people default, the debt recovery industry is growing, and its tactics are becoming increasingly aggressive. That’s the bad news.
The good news is that these guys are almost all bark and no bite! This is especially true for the deficiency judgement section of their business. Why? Well pretty simple, just look at the economics of it. Hiring minimum wage call center harassers and sending e-blast collection emails is very cheap. Hiring attorneys to do real assets searches and file real collection actions in real courtrooms is not! Unless you fit the 1% profile where spending money to collect against you makes clear economic sense, they are simply not going to do it. Instead they will rely on the shame, guilt, harassment and fear model to get you to cave. If you don’t they will eventually give up or settle with you for even less than they paid for your lead.
On top of that, once you understand both their methods and the legal options you have to stop their harassment in its tracks, the prospect of having your deficiency transferred to these guys is even less intimidating. The Federal Trade Commission (FTC), the nation’s consumer protection agency, enforces the Fair Debt Collection Practices Act (FDCPA), which prohibits debt collectors from using abusive, unfair, or deceptive practices to collect from you. Under the FDCPA, a debt collector is someone who regularly collects debts owed to others. This includes collection agencies, lawyers who collect debts on a regular basis, and companies that buy delinquent debts and then try to collect them.
Under these laws the collector must stop calling you if you request in writing that they do so. If they don’t then one call to the FTC should do the trick. In fact you have a lot of options and protection from both harassment and unfair or unethical behavior. For full details on how to handle aggressive collectors see the FTC website at: http://www.ftc.gov/bcp/edu/pubs/consumer/credit/cre18.shtm
I will never get any credit again
The final and biggest stick that is used to beat potential strategic defaulters into the ultimate feeling of shame, guilt and failure is the dreaded credit score! In my experience this is the single biggest fear people have on this issue. In fact, I have watched families give their last precious savings to a bank for fear of losing their credit, just to see the bank destroy it the minute they are bled dry anyway.
The fear is that once you ruin your credit, you are done for life and will never be able to buy a car, get a credit card, buy insurance, or even rent or buy a decent home. And this story is promoted by the entire debt-based machine of our Financial Industrial Complex! However, reality tells another story.
It generally takes only a few years for the negative consequences of foreclosure to disappear or become irrelevant. Assuming one had good credit before a default, and continues to meet other credit obligations, it is possible to get a good credit rating only two years after a foreclosure. If you default on your mortgage, it does not mean that automatically all your other credit lines will be revoked. If foreclosure was caused by unemployment or another extenuating circumstance, one can qualify for a federally insured FHA loan after three years. This term is extended to five years if there was no such a precipitating event.
Also, strategic default can be planned, and you can sign a rental contract for a new home, buy a new car, or secure other critical borrowing before starting the process of defaulting on a mortgage. In my conversations with other attorneys, we hear very often that many of their clients with strategic defaults on their credit records are suffering minimal adverse consequences in terms of finding new lines of credit or gaining employment. This is more true today than ever as foreclosures are now widespread and commonplace.
Think about it this way, which person would you rather hire or loan money to, one that makes an economically poor decisions based on mis-information and fear, or one who does the research and the analysis and makes a solid decision based on facts? I work with many very successful people and I can tell you that the more financially savvy the person is, the more likely they are to choose to strategically default. This goes the other way as well, the less financial experienced a person is, the more likely they are to let fear drive their decision and continue to throw good money after bad! Which one do you want to be?
SUMMARY SO FAR – The financial, legal and personal consequences of foreclosure, while real and worth considering, are often minimal compared to the personal, emotional and economic benefits of strategic default. So if a strategic default really makes sense, why is it that hundreds of thousands Americans who should be, aren’t taking this step? Because their answer is “Yes” to the following question:
Am I an immoral individual if I choose to Strategically Default?
We all have a set of core values. I have had the opportunity of knowing and being of service to some of the most successful people in America. There are two common core values that I see most, The Golden Rule “Do unto others what you would have them do unto you” and “You are only as good as your word”. In fact, in my experience most people I know and work with share both of these values.
I believe this is a tribute to the fact that the moral compass of America and Americans runs pretty deep. So absolutely, facing the feelings of doing something against what you feel like you have always stood for can be extremely difficult. Questioning any core belief can be one of the most challenging things you ever face. And the question, “ Should I stop paying a debt I agreed to pay?” calls into questions your beliefs at a very deep level about what is right and wrong.
With that being said, consider the following scenario. A 9 year old and a 5 year old kid are playing together when the 9 year old pulls out a coin and says “let’s bet on flipping this coin?” The 5 year old is happy to play any game and says sure! The 9 year old says “Heads I win, Tails you lose.” This elicits just pure excitement from the 5 year old who is already waiting for the coin to flip.
The coin goes up and lands on heads. The older child says, “Heads I win!” while the younger one just laughs and says “do it again!” The coin goes up and comes down, and the older says “Tails you lose!” Again the 5 year old just laughs and wants to keep playing. So far this is all just good fun, right? The older is playing a trick on the younger just because she can and this can go on for hours with the younger child never figuring it out (I have seen this happen with my own children, so I know it really can happen. The reason for this is that child development studies show that the concept of rationality doesn’t develop in children until age 7 or older. If this seems unbelievable to you, I suggest trying it for yourself.)
But here is my real question, “Once the older child moves into actually betting something of value to the younger child and taking the younger child’s things, would you consider it immoral if the younger child refused to pay up?” I believe 100% of us would say no, this is not immoral even if the child agreed to it, because morality is built upon the concept of a level playing field. You cannot apply level playing field morality to an unlevel field!
To all this you may be saying, “Doug, I am not a 5 year old child and this is not a relevant example for the situation I am in with my bank and my mortgage.” I would propose that it is directly relevant and that the difference between the average borrower and the Financial Industrial Complex is even more unbalanced than the difference between the children above. Consider the following:
- Banks are able to lend money and collect interest from you on money that they don’t have and don’t have to pay back if you default though the mechanism of “fractional reserve lending”
- Banks then create derivative products from your loan to make even more money by packaging and selling these bunched loans to investors and taking a huge commission.
- And guess who many of the “Investors” where? The very same retirement and pension plans of the very people whose loans were packaged and sold. DOUBLE WHAMMY!
- From 2001 to 2008, banks became so addicted to packaging and selling these loans that they fueled and encouraged millions of sub-prime loans which they KNEW were highly unlikely to ever get paid back and designed hundreds of no-interest and adjusting mortgage products for the sub and non-sub prime market which they KNEW would blow up after they had sold the loans and passed on the risk.
- They packaged these loans (yours included) and increasingly and fraudulently misrepresented the quality of these loans to investors making bigger and bigger commissions for their services, while leaving these investors with bigger and bigger undisclosed risks.
- The banks paid off the ratings agency to misrepresent and mis-rate these derivative instruments to maximize their profits in a direct and blatant fraud of which your mortgage was an integral part making you a necessary pawn in their Ponzi scheme.
- And to show that they really had no shame whatsoever, they then bet against the very instruments they created in the markets making obscene profits when they collapsed, as they knew they would, bankrupting AIG, the largest insurance company in the world, who was complacently on the other side of these bets in the process.
- This was done with the explicit and implicit approval and backing of the U.S. Government through Fannie May and Freddie Mac as well as the policies and actions of both the Republicans and the Democrats throughout the process.
- And when the extent of the damage exceeded what even the banks themselves thought could happen they pulled the strings on a controlled government to bail them out with you and your children’s future earnings, virtually enslaving your family for the next 3 generations to a national debt that should not even exist in the first place.
- They then took the bailout money, and went directly back to the casino and gambled it all, knowing that if they failed again they were too big for the government not to bail out again. This has lead to a wacky and unjustified run up in the markets and a false sense economic recovery which is only happening for the banks and major corporations as real inflation increases and phony profits soar. This is akin to solving a drug abuse problem with more of the same drugs!
- The banks closed down all lending, immediately spinning the globe into a credit induced global recession and refused to open back credit even while receiving trillions of our bailout dollars.
- What they did do with all those bailout dollars was immediately grant themselves massive bonuses for their brilliant fleecing of America and pay off the politicians re-election campaigns, guaranteeing to date not a single indictment and not a single person in jail despite blatant and massive fraud.
- And to top it all off, they are relentlessly foreclosing on every piece of collateral they can get their slimy greedy little hands on. They play nice with you if they see anything else they can get, promise to work with you as long as you add some more collateral to their pile. And stab you immediately in the back once they are satisfied that they have everything you own in their claws. They refuse to work with you to restructure anything that makes financial sense and use your own moral values against you in doing so while using shame, guilt and fear to attempt to extract your very last dollar from you before tossing you aside to the pile of serfs who are condemned to work for the rest of their lives to pay for their excess.
- They have engaged in an all out propaganda campaign to remind us all that the most valuable things we have is a meaningless credit score, which they themselves created less than 20 years ago, with endless television commercials designed to make you hyper aware that no credit means no life in America!
Please excuse my French, but this is pure unadulterated BULLSHIT! If you get one thing from this paper, please take away that if you chose to strategically default on your mortgage, you are not a bad person. I would go even further and propose that if you do not choose to strategically default, when it makes economic sense for you to do so, and you buy into their confiscation of America scheme, then you are more part of the problem in the job of Financial Industrial Complex reform than part of the solution. I would argue that it is morally correct for you to default on your mortgage and that the more of us who do, and do so loudly and without shame, the more likely we are to put the pressure on this dysfunctional system it needs to ultimately reform!
I hope I am being clear here, DROP THE GUILT and do what makes sense for you and your family, not for the banks! They have been more than taken care of by you already and the more passive and shame filled you are the less help you are to yourself, your family and your country. Holding this dysfunctional system accountable is both your right and your duty.
A Final word on Asset Protection
Many of you found this article on my website www.lodmell.com and know that I am an Asset Protection Attorney. So the question may come up, “How does Asset Protection play into my decision to default?” The answer for many of you is that it doesn’t. If you don’t have any assets or the ones you have left are already in a protected form like a 401K or life insurance policy, then you can make this decision without considering further asset protection.
For those of you who do have unprotected assets aside from the properties which you are considering defaulting on, then Asset Protection may be very important for you to consider. And this analysis is frankly not one that can be done in a generic way in this type of paper. If you think you may need asset protection or aren’t sure, then I would simply encourage you to call my office and schedule an appointment with me to discuss it. I can tell you that we have a tremendous amount of experience with this process and at the very least we will be able to help you make a better decision.
What options are available to you are highly specific to your situation, but timing is always a critical element.
I sincerely hope this article has been helpful to you and remember this is not your problem alone, it is our problem as a society. The better the individual decisions are, the better collective decision we ultimately make will be. This is a choice that is worth facing even your toughest beliefs, fears and emotions around. Don’t be afraid to do it. Thank you for taking the time to read this and I would be happy to hear your comments about anything contained here.
NOTE: The Information in this report is believed to be current and accurate; however, it does not constitute a legal opinion and should not be relied upon without verification by an attorney in your area qualified to give an opinion about your specific situation.