7 things consider before a strategic mortgage default

In the case of an unmanageable mortgage, a

In the case of an unmanageable mortgage, a home owner must evaluate carefully and decide whether there is a strong case to walk away to rebuild a life elsewhere. (Credit: iStock)

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Jill Zarin, one of the stars of the Real LI Blog

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No one wants to walk away from a home.

But they've become an increasingly bad investment for millions of Americans whose homes are worth less than they owe on their mortgage -- a lot less in many instances.

And no wonder.

Property values have fallen by more than one-third since 2006, wiping out about half of the $14 trillion in equity we had in our homes.

While many experts expected home prices to stabilize last year, they did not. They're continuing to fall in 18 of the 20 cities in the closely watched S&P/Case-Shiller index.

Tough choices must be made.

Does it make sense to keep pouring money into an asset in which you have no equity and that has little or no chance of generating a positive return for five years? Or 10 years? Or perhaps ever?

According to a study by the University of Chicago, more than one-third of all foreclosures are now the result of "strategic defaults," where homeowners decide to walk away even if they can afford to keep making the payments.

Here are seven reasons to consider a strategic default.

The more reasons that apply to you, the stronger the case for walking away from your home and rebuilding your life elsewhere.

Reason 1. It will be years before you can expect to have any equity in your home.

Equity is the difference between what you owe on your mortgage -- or mortgages, if you have more than one -- and how much your house is worth.

At one time, this was a great source of paper wealth for Americans.

But property values have fallen so much since the Great Recession that about 11 million borrowers, or one in five homeowners with a mortgage, now owe more than their homes are worth.

These underwater homeowners are the only ones that should be considering a strategic default.

If you have any equity in your home, there are better solutions than walking away.

But the further underwater you are on your loan, the stronger the case for a strategic default.

Jon Maddux, chief executive and founder of Youwalkaway.com, a company that helps with strategic defaults, says that becomes an option when you owe at least 15% more than your home is worth.

Reason 2. You're very pessimistic about what will happen to home prices in your area over the next five to 10 years.

No one can predict what will happen to home prices over the next few years, much less the next decade.

But many underwater homeowners will rise back to the surface more quickly than they think once property values bottom out.

In many cases, the decision to walk or wait depends on what you think will happen to the price of your home over the next decade.

Let's say you owe about 20% more than your home is worth.

Even if its value stagnates between now and 2020, just making your mortgage payments will reduce your balance by enough to reach the break-even point by then.

If you're optimistic enough to include even a little appreciation in that calculation, say 2% or 3% a year, you can regain positive equity in only three or four years.

This home equity calculator can help you predict how long it might take for your home to become a valuable asset again.

Reason 3. You can't lower the monthly payments.

It's easier to stick it out if you have a cheap mortgage with low payments that consume a relatively small portion of your income. If that's what you have, good for you.

Unfortunately, many underwater homeowners are stuck in expensive loans that charge 5 percent or more because they can't refinance to take advantage of this winter's record-low interest rates.

That's because banks and mortgage companies routinely require borrowers to have at least 20 percent equity to qualify for a new loan.

The federal government has stepped in and is now offering underwater homeowners new low-cost loans through the Home Affordable Refinance Program and Federal Housing Administration's refinancing programs.

We like these programs, but whether they will work is still up in the air. The federal government's previous attempts to push banks to help homeowners refinance have largely failed.

If your bank will not work with you on either a short sale or a restructuring of the mortgage that will make it an affordable place to live compared to what you'd spend on a rental in your area, and you do not qualify for a refinancing program, then it's time to consider walking away.

Reason 4. You're facing major repairs on the house.

Monthly payments are just one expense involved in owning a home.

Routine maintenance also drains money that you could be putting into other types of savings, such as retirement funds.

Springing for big expenses such as a new roof, for example, is like doubling down on your bet that you can wait out the downturn and benefit from positive equity some day.

Reason 5. You're prepared to deal with having your credit trashed for a few years.

According to a study conducted by Fair Isaac Corp., the company that calculates the widely used FICO score, expect your credit score to drop anywhere from 85 to 160 points if you walk away.

That's enough to drop most FICO scores into the low 600s, which will make it hard to borrow money for almost anything, such as a car, or open a new credit card, and anyone who is willing to finance you will demand sky-high interest rates.

It could even make it harder to get a new job because more employers are checking credit reports as part of the hiring process and a foreclosure is the kind of black mark they're looking for.

According to Fair Isaac, it will take two years of on-time payments and keeping other accounts in good standing to start rebuilding your credit to your pre-foreclosure levels, and it will take from three to seven years to make a full recovery (three if your pre-foreclosure score was 680, seven if your previous score was in the 720 to 780 range).

Reason 6. Your lender won't go for a short sale.

Never walk away without checking with your lender to see if it would be willing to do a short sale. This is where you sell the house for whatever you can and your lender forgives the remaining balance on your loan.

The benefit over foreclosure is that you leave debt-free, the bank can't come after you for the balance of the loan and you do less damage to your credit.

For a short sale with no balance owed, you can expect your FICO score to drop anywhere from 70 to 125 points, though it will still take three to seven years to return to your pre-short sale score.

Short sales are more likely to be offered to someone who is facing a crisis that makes the mortgage harder to pay, like illness, unemployment or a divorce, than to someone who wants to leave a bad investment behind.

But you still need to try. Here's more info on how to do a short sale.

Reason 7. Your lender is unlikely to pursue a default judgment against you.

In some states, lenders are allowed to sue defaulting homeowners to recoup their losses.

Never walk away without consulting with an experienced real estate attorney who knows the local laws and how your lender has acted in the past.

Some banks aren't bothering with pursuing default judgments -- they just have too many foreclosures on the books or realize that it's not within their financial interest to go after money from people who most likely don't have it.

But you need to know the risk.

The last thing you want, four or five years down the road, is to have your former lender haul you into court demanding hundreds of thousands of dollars.

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