Mar202013

Borrowers who strategically defaulted early on made the best choice

I first began writing about strategic default back in 2008 in the post Should you walk away from home debt?. Many people were facing a cost of ownership greatly exceeding the cost of a comparable rental, and with declining prices, they were sinking underwater and had no realistic hope of future equity. On a purely financial basis, it was wise to strategically default. The shortest path to equity was to walk away from the huge debt, save money, and wait until the credit scores improved enough to repurchase again at lower prices. I gave that advice frequently from 2008 through 2011, and recent stories from boomerang buyers are proving that thesis correct.

Calif. couple shows there’s life after foreclosure

By Ben Tracy — March 14, 2013 7:24 PM

(CBS News) PALMDALE, Calif. — Three years ago, Susan and Dave Edwards stopped paying the mortgage on their house in Palmdale, Calif.Asked how tough it was to walk out the door to their home one last time, Susan says, “It wasn’t tough, it was freedom.

“We’ve never not paid our mortgage, never, and we have been married 35 years, and we have always paid our bills,” she says.

Strategic default is never an easy choice. In my opinion, walking away from mortgage debt is the best way to secure your children’s future. Many didn’t heed my advice, and they are paying a heavy price for their principled approach.

Their mortgage was $340,000, but Susan says their home’s worth had dropped to $190,000.

“So we decided we just had to let it go,” she says. “To walk away.”

She says she and her husband were ashamed.

“We didn’t talk about it at all, and I didn’t want anyone to know,” Susan says.

After the bank foreclosed, their credit dropped, so they rented an apartment.

“I would have probably told you at that time, ‘I will never own a house again,'” Dave says.

Feelings of despair and failure go with the decision. They are the negative flipside of the feeling of freedom that came with ditching the huge mortgage.

But then Susan heard about a Veterans Administration home loan program. Her husband was stationed in Korea during Vietnam. Even though they walked away and foreclosed on their home, Susan thought they were good customers for a loan.

“Crazy, I guess, but I did,” she says. “Because I felt like we were justified in what we did, somewhat. We weren’t going to do it again.”

Even those people who deep down feel they did something wrong eventually find justifications and rationalizations to make them feel better about doing what they had to do for their family. These conflicting emotions are natural to anyone who is forced to chose between two competing values: in this case, keeping your word and protecting your family.

They were pre-approved the next day. They bought a house just one mile from their old one. Their new loan is $163,000 cheaper, with a 3.25% interest rate. They now pay $1,150 each month.

These people reduced their cost basis and mortgage payment by more than 50%. If they had stayed in their old property like many of their neighbors did, they would still be making that onerous payment and deeply underwater. By the time their neighbors have equity again, they will be $150,000 ahead and considering selling to buy a move-up home. Timing the housing market is important.

Asked what she would say to people who are making payments on underwater mortgages, Susan says, “Life isn’t fair. We never broke the law, and everyone is entitled to their opinion, and I can live with that.”

She also says it should give people hope that even if they lost their house, another one may be just down the road.

Except in the most beaten down markets, strategic default doesn’t make as much sense today as it did from 2008 to 2011. Last year I opined, Rising home values will halt strategic default. It has. The incentive now is to wait until prices rise back to the peak where borrowers in cloud inventory can sell without damaging their credit. Defaulting now misses the rally, whereas defaulting in 2008 missed the decline.

Strategic default was an opportunity for loanowners who had the courage and foresight to act on it. Unfortunately, the window of opportunity has closed.