Strategic Default: When Foreclosure Makes Sense For You

Foreclosure. When you think about it terms of yourself, it sounds really bad, doesn’t it?  For some it even feels morally wrong.  Let’s face it, you undertook an obligation.  We live in a society where we have been conditioned to fulfill our obligations at all costs, and let this be clear: We should all strive to honor our obligations.  But, there are certain types of obligations and certain circumstances around those obligations that make strategic default the right economic and the right moral choice.  A strategic mortgage default may just represent one such scenario.

The economic analysis on strategic mortgage defaults is fairly straightforward.  A fictional person, let’s call her Grasshopper, buys a condo in downtown Miami for 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%.  And 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 bank account.  Reality Check: The market CRASHES.  Grasshopper’s condo loses 40% of its value (now worth only $210,000).

Unfortunately, Grasshopper’s scenario is 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 bank account after refinancing, Grasshopper is still in a bad situation, because she has a $350,000 mortgage on a condo worth only $210,000.  It’s obvious, in this scenario, that Grasshopper should walk away–she should stop paying her mortgage (default) and let the condo go into a foreclosure sale.  This is actually 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”).  The moral choice is discussed in Strategic Default is Sometimes the Moral Choice.

In terms of doing what’s best for herself economically, the clear answer can be found by switching some of our hypothetical facts around and asking a very simple 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!” which is the same answer that applies to Grasshopper.  The only thing we have changed in this example is the timing of the unfavorable debt to value ratio, which highlights a very important point that cannot be overemphasized: Real estate fluctuates in value!  Even more important than that 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 very similar to the stock market.  And like the stock market, real estate then becomes the subject of drastic price swings.

To sum this up, strategically defaulting on a mortgage is the right economic choice.  It never makes sense to knowingly pay more for something than that thing is worth.  The takeaway, however, is that people like Grasshopper are not solely to blame for the current situation, the real estate bubble, or speculation.  As a result, people like Grasshopper should not have to solely suffer the consequences.  More on this topic in the next post, so stay tuned . . . .