Banks have always been aware of the risks of lending. Interest rate pricing has risk factors built into the models to account for the probability of loan portfolio default. But what about strategic defaults; loans in which the borrower’s can afford to pay their mortgages but choose to voluntarily walk away? Ever since the financial meltdown in 2008 this has become more and more prevalent. What is most alarming is that it is becoming an acceptable option.
When the housing bubble burst many homeowners felt unnerved due to the alarming rate at which home values were decreasing. In some instances values fell almost 50%, leaving homeowners totally underwater (mortgage balance >home value). With multiple lender based and government loan programs failing to offer assistance, many turned to what was an unthinkable option just a couple of years before; walking away from a home they could afford.
Strategic defaults have a profound effect on the market in that they drop the value of comparable properties in the area due to discounted short sale or foreclosure sale prices. While involuntary defaults are unfortunate, some are calling strategic defaults flat out immoral. But are homeowners truly immoral if all they are doing is attempting maximizing their utility? After all, they are honoring their contract by forfeiting the home, right?
Whether we like it or not one of the key reasons that people are walking away from their homes is because they are no longer worth what the paid for them. How could an individual walk away from their home and increase their utility in the process? One way would be to rent or purchase a new home, at a discounted price, that is comparable to the one they walked away from. I understand that there is more to this scenario that just simply moving to a new house, but when you think about it the idea makes sense.
Let’s assume that a person owes $250,000.00 on their home that is now worth $150,000.00. The principal and interest payment on that property would be $1,342.00 per month (at 5% over 30 years). That exact same home, now worth $100,000.00 less, would have a monthly payment of $805.23 (5% over 30 years). That is a difference in discretionary income of $536.77 per month.
In the article, Strategic Mortgage Default: The Irresponsible, Amoral, But Best Strategy?, the author cites an expert that states homeowners should walk away from underwater mortgages because it would be stupid to do otherwise. From an economic standpoint it would make sense that a borrower would walk away. They could potentially rent or purchase (if they qualify) a similar home a discounted price without sacrificing their utility. In fact it would increase their utility in the short run.
If a person walked away and saved $536.77 per month, that would immediately impact their utility due to the increase in discretionary income available. This would allow them to purchase/rent more housing (larger home, better neighborhood, etc.) or apply the additional income to the purchase of all “other” goods. As seen in the graph above, this would rotate the individual’s budget line out and to the right due to the drop in housing price, resulting in the ability to purchase more “other” goods while maintaining the same level of housing that they previously had; increasing their utility in the process.
Not every homeowner in a similar situation could envision following through with a strategic default, and it may be due to the long term residual effects from doing so. First off, many homeowners take pride in the fact they honor their obligations. Whether or not “experts” advise that walking away from an underwater mortgage is the best strategy in a business sense, many people have too much pride to do so. Also many people understand that while in the short term this would provide an increase in utility, the long term effects could be devastating. Letting a mortgage go into foreclosure would have a profoundly negative effect on their credit rating. Most banks will not lend to an individual that has had a foreclosure within the last 7 to 10 years. Not only would it hinder your ability to purchase a new home down the road, it would potentially prevent you from obtaining any credit whatsoever.
While logically it would make sense to walk away from an underwater mortgage, every individual would need to assess the long term effects of the short term gain. A home is a long term investment, and not a source of cash, as made popular by increasingly easy access to a home equity loans over the last few years. Whether or not people feel duped, they need to look at their home and mortgage over the long term to make the best economic decision.