Home > Mortgages > The Hidden High Cost of Strategic Default

Comments 0 Comments

If you’re one of the 28% of U.S. homeowners with a mortgage that’s higher than your house is currently worth, is it time to toss the keys to your lender and walk away?

According to Zillow’s third quarter Negative Equity Report, some 14 million people owe an estimated $1 trillion more on their mortgages than their homes would sell for in today’s depressed real estate market. Perhaps that helps explain why a recent ID Analytics survey estimated that 32% of all adults in the U.S. (nearly 68 million people) say they would be comfortable with the notion of strategic default.

Homeowners who tactically elect to default on their mortgage obligations aren’t typically short on cash, nor are they in financial distress. Rather, they have the means to make their monthly payments but choose not to do so for a couple reasons: their mortgage loans are underwater and they happen to live in states that have enacted so-called anti-deficiency legislation.

The concept behind these laws is fairly straightforward — to protect against or limit the extent to which lenders are able to pursue hardship-experiencing consumers for the difference between what their foreclosed upon houses ultimately sell for and the unpaid loan balances. The laws vary from state to state and are focused on first mortgage loans for primary residences as opposed to second mortgages (homeowner’s equity lines of credit and loans) and financing for vacation houses and investment properties.

On the surface, at least, the motivation appears to have been well intended — helping those who’ve lost a basic human need: a place to live. However, as it too often happens, good intentions are undermined by heavily rationalized self-interest.

In this case, strategic defaulters make two arguments. The first is that it’s the banks’ and mortgage brokers’ fault — they knew housing prices were overvalued and they also knew that consumers were getting in over their heads, but they approved the loans anyway. The second has to do with companies that have, according to those making the argument, reneged on their loan commitments, without suffering the consequences. So why shouldn’t consumers be able to do the same?

Taking the loan approval argument first, I thoroughly agree with the assertion that those lenders and intermediaries who are guilty of malfeasance should pay the price for their actions, although we’ve seen astoundingly little of that to date. In fact by most reports, the financial industry’s hasn’t done nearly enough to address the impaired values of the under-collateralized mortgage loans that are currently on their books, let alone to help the financially distressed mortgagors who continue to struggle to keep up with their payments.

As for the “If the company can do it, why can’t I?” half of the argument, sorry, it doesn’t wash. Subject to the structure of the contract and the corporate entity to which the loan was made, default is rarely a “no harm, no foul” proposition. For example, in my previous life, the loans my companies routinely made to commercial borrowers typically included “cross-collateralization” and “cross-default” language, which permits lenders to claim additional property and to place all of a borrower’s loans into default at the same time even if only a single loan heads south. Moreover, companies that willfully defaulted on their obligations were branded untouchable by the lending community for years to come.

Setting aside for the moment all the legalities, tactics and opinions that make strategic default such a controversial and interesting topic, I see it as an opportunity to think about the consequences of when ethics T-bones morality at the intersection of What I Can Do and What I Should Do.

Although anti-deficiency laws weren’t intended to encourage this type of behavior, they have yet to be modified or repealed. Therefore, strictly speaking, it is not unethical to take advantage of what the law permits. But is it moral? Consider this:

Credit is based upon trust: I trust that if I lend you money, you’ll do all you can to pay me back. However, should you choose not to pay me back, especially when we both know you have the financial wherewithal to do so, it’s going to affect how I operate in the future.

All lenders make four, basic decisions on every loan request they receive: whether they want you as a customer, how much they’ll be willing to lend to you if they do, how much to charge you for the loan they decide to make and the contractual terms and conditions to require. With that in mind, imagine how lenders that do business in anti-deficiency legislation-states will adjust their underwriting standards to take this added risk into effect. They’ll want higher down payments to offset the potential for a loan-to-value shortfall, higher rates and fees to offset the added risks and tighter loan covenants to ensure that they’ll have the ability to pull the trigger that much faster if you start to get creative.

Borrowers that elect to strategically default on their loans may indeed be able to walk away with their financial holdings intact, at least for the time being. However, those who follow will most certainly be made to pay the price. So, is strategic default moral? You decide.

This story is an Op/Ed contribution to Credit.com and does not represent the views of the company or its affiliates.

Image: Sadie Hernandez, via Flickr

Comments on articles and responses to those comments are not provided or commissioned by a bank advertiser. Responses have not been reviewed, approved or otherwise endorsed by a bank advertiser. It is not a bank advertiser's responsibility to ensure all posts and/or questions are answered.

Please note that our comments are moderated, so it may take a little time before you see them on the page. Thanks for your patience.

Certain credit cards and other financial products mentioned in this and other sponsored content on Credit.com are Partners with Credit.com. Credit.com receives compensation if our users apply for and ultimately sign up for any financial products or cards offered.

Hello, Reader!

Thanks for checking out Credit.com. We hope you find the site and the journalism we produce useful. We wanted to take some time to tell you a bit about ourselves.

Our People

The Credit.com editorial team is staffed by a team of editors and reporters, each with many years of financial reporting experience. We’ve worked for places like the New York Times, American Banker, Frontline, TheStreet.com, Business Insider, ABC News, NBC News, CNBC and many others. We also employ a few freelancers and more than 50 contributors (these are typically subject matter experts from the worlds of finance, academia, politics, business and elsewhere).

Our Reporting

We take great pains to ensure that the articles, video and graphics you see on Credit.com are thoroughly reported and fact-checked. Each story is read by two separate editors, and we adhere to the highest editorial standards. We’re not perfect, however, and if you see something that you think is wrong, please email us at editorial team [at] credit [dot] com,

The Credit.com editorial team is committed to providing our readers and viewers with sound, well-reported and understandable information designed to inform and empower. We won’t tell you what to do. We will, however, do our best to explain the consequences of various actions, thereby arming you with the information you need to make decisions that are in your best interests. We also write about things relating to money and finance we think are interesting and want to share.

In addition to appearing on Credit.com, our articles are syndicated to dozens of other news sites. We have more than 100 partners, including MSN, ABC News, CBS News, Yahoo, Marketwatch, Scripps, Money Magazine and many others. This network operates similarly to the Associated Press or Reuters, except we focus almost exclusively on issues relating to personal finance. These are not advertorial or paid placements, rather we provide these articles to our partners in most cases for free. These relationships create more awareness of Credit.com in general and they result in more traffic to us as well.

Our Business Model

Credit.com’s journalism is largely supported by an e-commerce business model. Rather than rely on revenue from display ad impressions, Credit.com maintains a financial marketplace separate from its editorial pages. When someone navigates to those pages, and applies for a credit card, for example, Credit.com will get paid what is essentially a finder’s fee if that person ends up getting the card. That doesn’t mean, however, that our editorial decisions are informed by the products available in our marketplace. The editorial team chooses what to write about and how to write about it independently of the decisions and priorities of the business side of the company. In fact, we maintain a strict and important firewall between the editorial and business departments. Our mission as journalists is to serve the reader, not the advertiser. In that sense, we are no different from any other news organization that is supported by ad revenue.

Visitors to Credit.com are also able to register for a free Credit.com account, which gives them access to a tool called The Credit Report Card. This tool provides users with two free credit scores and a breakdown of the information in their Experian credit report, updated twice monthly. Again, this tool is entirely free, and we mention that frequently in our articles, because we think that it’s a good thing for users to have access to data like this. Separate from its educational value, there is also a business angle to the Credit Report Card. Registered users can be matched with products and services for which they are most likely to qualify. In other words, if you register and you find that your credit is less than stellar, Credit.com won’t recommend a high-end platinum credit card that requires an excellent credit score You’d likely get rejected, and that’s no good for you or Credit.com. You’d be no closer to getting a product you need, there’d be a wasted inquiry on your credit report, and Credit.com wouldn’t get paid. These are essentially what are commonly referred to as "targeted ads" in the world of the Internet. Despite all of this, however, even if you never apply for any product, the Credit Report Card will remain free, and none of this will impact how the editorial team reports on credit and credit scores.

Your Stories

Lastly, much of what we do is informed by our own experiences as well as the experiences of our readers. We want to tell your stories if you’re interested in sharing them. Please email us at story ideas [at] credit [dot] com with ideas or visit us on Facebook or Twitter.

Thanks for stopping by.

- The Credit.com Editorial Team