There are many homeowners who have found themselves in the unfortunate position of being underwater on their home. Some of these homeowners live in a neighborhood where home values have declined, and others took out too much in home equity loans. In some cases both happened.
While it’s understandable that these homeowners are frustrated, some have decided to simply walk away from their homes, even though they can afford to make their monthly mortgage payments. This is known as strategic default. There are numerous problems with the decision to walk away from one’s home when the borrower has the ability to pay.
Let me tell you a story.
The house across the street has sat empty for the better part of a year. According the neighborhood gossip, the owners—a young couple with no kids—walked away from the underwater mortgage. Apparently, the husband, who worked as a manager for a national restaurant chain, was transferred to another part of the country, and the couple figured it would be easier for them to simply mail the keys to the bank rather than deal with the financial headache.
There has certainly been a great deal of tut-tutting in the neighborhood over this (alleged) decision. But it got me wondering what this couple will deal with (other than our neighbors’ scorn) because they decided to default on their loan. If you are in a similar situation—where you can’t afford to continue paying your underwater mortgage—please know that walking away can seriously affect your financial future. Not to mention your standing in a neighborhood.
Is Walking Away from Your Mortgage Moral?
First, there is a moral aspect to the decision. You signed a contract and agreed to pay a monthly price for your home. Unless the contract had a stipulation that you can walk if your home’s value falls – and I’m not aware of a single mortgage contract like that – you are not fulfilling your obligation. Some will argue that it’s a business decision, but I think it’s more than that. After all, would a homeowner whose home appreciated in value call it a “business decision” if the bank decided to increase their mortgage payment as the home’s value rose? I seriously doubt it.
I believe we are all obligated to honor our contracts unless there are extenuating circumstances which prevent us from doing so.
I want to be very clear that when I talk about the moral aspects of walking away from a home, I’m talking about people who can afford their payments. I know first-hand that there are people out there who really cannot afford to make their payments and want desperately to stay in their homes. Those people may not have a choice when it comes to giving up their home.
Who Does Walking Away Hurt?
In essence, walking away hurts the homeowner who is walking and every other homeowner out there. As homes are sold as short sales or foreclosures, the values of neighboring properties decline. If homeowners walk away from homes they can afford, it just perpetuates the cycle. The only way neighborhoods are going to recover is for homeowners to hang in there and watch out for one another.
I’m a fairly optimistic person, and I truly believe the tides will change and properties will eventually regain their values. Those who think they’ve lost the equity in their home forever are really creating a self-fulfilling prophecy by contributing to declining property values and adding to the amount of foreclosures and short sale homes that are sitting on the market.
How a Foreclosure Affects Your Finances
There are many long-term affects of having a foreclosure on your record.
1. Your credit will take a hit
This is the most obvious consequence of defaulting on a mortgage, and one that many desperate homeowners are willing to face. It’s important to note that after a default, your credit score will not only go down, but you may also find that your credit cards are canceled or have their limits lowered. You can also put your plans for buying a car or furniture on hold unless you can pay in cash, as it will become very difficult to obtain financing on big ticket items. Finally, it will be anywhere from three to seven years before you can qualify for another mortgage.
However, remember that non-default options can also negatively affect your credit. If you agree to a short sale—where you keep possession of the house and maintain it while trying to sell it on the bank’s behalf, generally within a two to three month time frame—you also will see repercussions in your credit score. The difference is that you will be able to apply for a home loan again sooner.
2. You may have a hard time finding a place to rent
Homeowners who think that they can walk away from their homes, rent for a bit and start over are going to be in for a big surprise.
When someone lets their home go into foreclosure, it harms their credit score and leaves a black mark on their credit report. It’s a black mark that will stay on their credit report for seven years. Many landlords do credit checks on their potential renters. Seeing a foreclosure is likely going to be a red flag to the landlord that you’re not capable, or willing, to make your rent payments on time.
The foreclosure is also going to be a red flag to lenders if the homeowner would like to buy a home or take out any new credit in the next seven years. In addition to the decision of whether or not to give a potential homeowner a mortgage, lenders also base interest rates on the borrower’s credit score. The borrowers with the best credit scores get the best mortgage terms and/or interest rates. A foreclosure is going to put the borrower in a bad position when it comes to getting credit … if they can get credit.
I should also point out that it can be more expensive to rent than buy in some markets.
3. You may have to pay the difference between what the bank was able to get for your home and what you owe
This is called the deficiency, and in most states in the union, it’s perfectly legal for your lender to sue you for that difference. Again, this is a possibility even if you go through a short sale, so know that being underwater does not leave you many good options.
Even if you live in one of the few states with anti-deficiency laws, you may still be liable for the difference depending on if you have taken out a second mortgage, if you have refinanced to take cash out of your home’s equity, and if you are still paying your original mortgage. No matter what your situation, if you are considering defaulting or short selling, you will want to consult with a real estate attorney to determine how best to protect yourself.
4. You can’t escape the Tax Man
When the mortgage crisis first hit in 2007, the Mortgage Forgiveness Debt Relief Act was created to offer protection to troubled homeowners—including forgiving federal taxes that would otherwise be due on a foreclosed home. Unfortunately, state taxes do not have to follow this law, and so walking away from your home may burden you with a state and/or local tax bill. The tax liability when defaulting on a second home or an investment property can be even higher.
Options That May Help You Avoid Foreclosure
It’s always a good idea to examine all your options before walking away from your mortgage. As you saw from above, having a foreclosure on your record can have along-term negative financial impact.
A couple of options to consider:
- Seek Financial Counseling ASAP – a HUD-certified housing counselor. Many non-profit agencies all across the country offer these services for free. You can find a certified counselor in your area at the HUD web site (www.hud.gov). The counselor will go over the borrower’s whole financial situation, explore all the available options and give the client crisis budgeting tips. These counselors can work directly with lenders.
- Check with your state for mortgage programs. Some states have programs to help those who are struggling with their mortgage.
- Home Loan Modification Program – Contact your lender to see if they offer a mortgage modification program for people going through financial hardship. You may be able to qualify for an interest rate reduction or extend your term beyond your current term. The latter would lower your monthly payments, but you would pay for a longer period of time.
- Short Sale – If you really think you might be facing foreclosure, this might be a good option to consider. I am no expert on them, but know enough that while it won’t solve all of your problems, it might relieve a good bit of the stress. You could then rent something for you to live in until you get back on your feet.
- Rent – Have you thought about renting the house out? If you could rent it for your payment, that would cover the mortgage. You could then find someplace less expensive to rent and live in, again until you get back on your feet. Once back, you could move back into the house once the tenants lease was over.
- Rent out a room – I’m not sure how your home is laid out, but have you considered renting out a room? If you could get some help with that mortgage by renting out a room to someone, that might help out enough for you stay afloat for a while.
- The last resort – Foreclosure – A foreclosure is not always the end of the world. While you would lose your home and impact your credit it would get rid of the financial obligation. You could then find a place to rent while you get things back in order.
The Bottom Line
Allowing a home to go into foreclosure clearly isn’t something that should be taken lightly or decided quickly, especially if the homeowner can afford the monthly payments. I would urge people to consider all of the long-term effects of a foreclosure, including their plans for the next seven years, before making a final decision.
If you’re in trouble, it’s time to call in some experts. Consulting with a real estate lawyer and an accountant may seem like more money than you can afford when you’re possibly facing a major financial crisis—but the cost of a mistake could be even greater than their fees. You want to know exactly what the consequences of your actions will be before you make a decision that could still cost you for years to come. They may also be able to direct you to some programs which may help.
Kristen Doerschner is the public relations coordinator for a non-profit debt relief agency and a freelance writer. Through her writing, Kristen covers a variety of topics, but specializes in issues related to financial education.
Photo credit: Adam Melancon