Stay and Pay or Walk Away?

CU360
June 4, 2010 | COMMENTS

What would you do—stay or walk away? That's a question more Americans are asking as the housing market continues to struggle.

Say you bought a home two years ago in one of the “sand states”— Arizona, California, Florida, or Nevada. Whatever you might have paid, you still owe nearly that amount—but your home's value has dropped by as much as $100,000. In this scenario, you're like many other homeowners, agonizing over the pros and cons of a “strategic default.”

A growing number of people in areas where home prices have plunged are considering whether to walk away from their mortgages, not out of necessity but because they believe it's in their best financial interests. The debate—both practical and moral—is heating up, reports The Wall Street Journal.

A standard mortgage-loan document reads, "I promise to pay" the amount borrowed plus interest, and some people say that promise should remain good even if it's no longer convenient. Borrowers who can pay, and weren't deceived by the lender about the nature of the loan, have a moral responsibility to keep paying. Anything else would be disastrous for the economy and for mortgage lenders.

Others suggest that homeowners should make the decision on whether to keep paying based on their own interests, “unclouded by unnecessary guilt or shame.” In fact, more borrowers seem to be taking a cue from lenders that they perceive as ruthlessly and irresponsibly seeking to maximizing profits.

Walking away isn't risk-free. A foreclosure stays on a consumer's credit record for seven years and can send a credit score (based on a scale of 300 to 850) plunging by as much as 160 points, according to the Fair Isaac Corporation. A lower credit score means auto and other loans are likely to come with much higher interest rates, and credit card issuers might charge more interest or refuse to issue a card.

And many states give lenders varying degrees of authority to seize deposits, cars, or other assets of people who default on mortgages.

Even so, in neighborhoods with high concentrations of foreclosures, “it's going to be really difficult to prevent a cascade effect” as one strategic default emboldens others to take that drastic step, says Paola Sapienza, a professor of finance at Northwestern University. As many as one in four defaults may be strategic, according to a study by researchers at Northwestern and the University of Chicago.

Negative equity drives defaults

Driving this phenomenon is the rising number of households that are deeply “underwater”—owing much more than the current value of their homes. In the first quarter of 2010, the percentage of single-family homes with mortgages in negative equity stood at over 23%, up from 21% in the fourth quarter of the previous year. The problem is concentrated in Arizona, California, Florida, Michigan, and Nevada.

Another concern is that delinquencies among prime mortgages—the largest category of home mortgages—continue to climb. In the first quarter, almost 21% of foreclosure starts were for adjustable-rate mortgages held by credit-worthy borrowers, according to the Mortgage Bankers Association. Fixed- and adjustable-rate prime mortgages combined accounted for more than 57% of all new foreclosures. More than 6% of fixed-rate prime mortgages were delinquent between January and March, and more than 13% of homeowners with adjustable-rate prime mortgages were behind on payments.

Banks warn they may get tough with strategic defaulters by pursuing a borrower's other assets in states that allow such actions. Another risk for defaulters is that banks could sell the rights to pursue claims to collection agencies or other firms, which could then dun the borrowers for up to 20 years after a foreclosure. Such threats appear to deter some borrowers. Underwater borrowers were 20% more likely to default in a state where mortgage lenders can't pursue claims on other assets than in those where they can, according to a recent study from the Federal Reserve Bank of Richmond.

This article was orginally published online by CU360, an online portal for benchmarking tools, market insights, industry data, and analytical information at cu360.cuna.org. Reprinted with permission.