The Economics of Ditching Your Mortgage

For a recent story I did about underwater mortgages, I spoke with a lot of people who owe more on their mortgage than their homes are worth. Inevitably, these people would acknowledge the option of just walking away: giving up on paying the mortgage and leaving the house to foreclosure. Just as inevitably, they would quickly add, “I would never do that.”

There seem to be two camps on walking away. First, there are those who think it unethical and shameful for a person to default on an obligation. And second, there are those who think walking away is nothing compared to the wrongs committed by bankers who profited from making bad loans and the Wall Street firms who gambled with mortgages. (Readers from each camp are debating the issue in the comments section of a recent More Money post.)

Putting aside ethics for a moment, I wonder about the economics. At what point does it make financial sense to default?

For borrowers who are more than 25% underwater — particularly in higher-priced homes where negative equity can top $100,000 — not walking away is economically irrational, writes Arizona law professor Brent White in a paper published in February. “Once one is 40% or more underwater,” he argues, “the financial logic of strategic default is frequently overwhelming.” Given the state of the housing market — one out of four homes are underwater — it’s surprising that more people aren’t just moving on and leaving the keys behind, he says.

Several variables play into the mathematics of default. One is the spread between your mortgage payment and area rents — what you’d pay to rent a comparable house. Others are the amount you’re underwater and the outlook for real estate recovery in your area.

To see how all these numbers might come together, take a look at this scenario from Indianapolis financial planner Michael Kalscheur, based on the situation of a family he helped:

Let’s say you owe $315,000 on a $375,000 home that’s now worth $225,000. Your payment is $2,600 a month, but you can probably rent a decent place for $1,600 a month.

Option One: You walk away. At the end of seven years — when the foreclosure is gone from your credit report — you’ll have saved $84,000 in payments by living in that rental home.

Option Two: You stay in your home. Assuming, perhaps optimistically, that housing prices start appreciating again at their traditional 3% rate, your home will after seven years be worth about $275,000, and you’ll have paid down your mortgage to perhaps $260,000. In other words, you would have paid $218,400 over seven years to have $15,000 in home equity. (But, you might ask, doesn’t the mortgage-interest tax deduction have a value for non-defaulters? Well, real estate pros say the value of writing off interest payments on taxes is easily cancelled out by the expenses of maintaining a home and selling it.)

Now, Moody’s report says 62% of major metropolitan areas will return to pre-recession peak housing prices by 2015. So if you live in one of these areas, and your loan terms aren’t too painful, it’s probably best to ride it out. But what if you bought near the peak in some of the hardest-hit areas of Florida, Nevada or California — which aren’t predicted to retake those heights until 2030, or even 2040? Then making a house payment is equivalent to renting, since you’re not building equity.

And what are the economic repercussions of the damaged credit score you’d end up with by walking away? A foreclosure, whether strategic or not, stays on your credit history for seven years, although its impact on your credit score declines over time. In the short run, someone with a 780 credit score will see that cut by as much as 160 points, according to Fair Isaac’s myFico; that can affect everything from insurance premiums to your employment. But if you keep all your other bills paid up, your score can begin recovering in as early as two years.

Clouding the economics, however, are certain misguided beliefs. Many mortgage-payers, says White, overestimate the speed with which home prices will bounce back, as well as the negative impacts of a foreclosure. Yet the sense of fear, shame and failure associated with default, and the belief that we are responsible for paying our obligations, are for most of us simply too strong.

I know the families I interviewed felt that way, many of whom were simply victims of bad timing. I could also feel their frustration over the fact that for them, their house would never be an opportunity to build wealth.

Can you imagine yourself strategically defaulting on a home? Take the survey below.

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