When should I walk away from my mortgage?

Question

I bought my home in California in 2006, at the height of the boom. Now I owe $100K more than the home is worth.

California is a "no recourse" state; if I stop payments, the bank can take the house and ruin my credit, but that's about it.

So I'm considering walking away from my mortgage, to save $100K (plus interest).

(The bank won't approve a short sale because I'm not in a financial hardship; I can afford the mortgage, it just seems foolish to pay that much to protect my credit.)

Is $100K (plus interest) worth 7 years of bad credit? $200K? $1M? How much money is good credit worth?

Answer 1

The value of debt is that it allows you to profit from the return of equity beyond the amount of actual net equity you own. Of course, this only works if the cost of borrowing is less than your return on equity. Market timing matters a great deal but isn't accounted for in this view. For my answer I would like to hand-wave away market timing considerations. One plausible justification is that you could default on your current home and then immediately go buy one of equal value. If you buy a new home of a lesser value (due to lack of funds) and then prices appreciate, then you missed some opportunity cost but probably not $100k worth of it.

Moving on, here are some helpful assumptions I'll make.

• You currently have a net worth of P
• Borrowing with good credit (which you have now) costs you R1 % yield, with a limit of A1
• You simply don't borrow at all if you have bad credit
• The time value of money to you, or your average investment yield is R2 %
• You make S dollars per year at your job more than what you spend
• You will retire in X years.

I'll ignore performance of your portfolio after retirement and only seek to optimize F, which will be your net worth upon retirement. In either case, your current net worth is earning the R2 rate. We can convert this for both your current net worth and future savings using conversion formulas.

Present to future value

F = P (1+R2)^x

Annual to future value

F = S ( (1+R2)^x - 1 ) / R2

Adding these together is sufficient to obtain F in the case that you have no borrowing power. The case where you do not default and maintain your credit score is different due to an initial $100k penalty and the amortized value of borrowing power. In a completely theoretical sense, you get an effective (R2-R1) yield on all borrowed money. The future value will be the following:

F = A1 (1+R2-R1)^x

One step is missing, however, which is to convert this value (the value of having a good credit score) into present value to compare to value of your defaulting.

P of borrowing power = F / (1+R2)^x = A1 { (1+R2-R1)/(1+R2) }^x

Now, let's put some specific values in. Say that you can borrow $300k with your good credit history and this applies for the next 25 years, after which you retire. The borrowing rate is 7% and the time-value of money to you is 10%. I would then calculate:

P of borrowing power = $58 k < $100 k

This indicates that it would be more economical to default. Of course, some people might point out that it will be removed from your record after 7 years. If you plug 7 years instead of 25 years into the equation, almost no assumptions about rates will lead to the option of keeping your house being preferable.

So in a nutshell, the value of your credit is probably less than $100k in a purely mathematical sense. But there are other factors too. If you don't have that borrowing ability maybe you wouldn't be able to borrow money to start the business of your dreams. If you are a rock star entrepreneur, then time-value of money to you could be 1,000% yield, sure, then maybe you could make the above numbers work (to favor keeping the house). I've also neglected ethics. As other people point out, it would be like stealing from the bank.

Answer 2

I'm in a similar situation, but I live in a state that doesn't allow mortgagees to "walk away" without recourse.

I would consider a short sale or otherwise abandoning the property if:

• I was facing imminent bankruptcy, and abandoning the property would allow me to move to get a job or something similar.
• I made a very bad decision, and purchased a home using a mortgage that will rapidly become unaffordable at some known future point. (ie. balloon payment, negative amortization loan where you need to pay the piper, etc)
• Some external event permanently outside reduced the value of my home, and materially impacted my ability to live there in some way. Something like construction of a factory, mine, pig farm or similar noxious neighbor.
• Something happened that put the health and safety of my family at risk. Say an industrial accident that poisoned the groundwater, and no city water was available. Or a 1970's Detroit-style rapid disintegration of the city.

At the end of the day, real estate is an investment, and you don't realize gains or losses until you close the position. The "ra, ra" crowd that thought that real estate was going to boom forever in 2006 was just as wrong as the "bad news bears" crowd that thinks that real estate will never recover either.

Investments rise and fall. Many people who bought houses in the 1980's boom (recall the S&L crisis) were underwater for years until prices started rising in the mid-90's. You haven't lost money until you realize that loss.

Answer 3

How much is rent in your area? You should compare a rental payment versus your mortgage payment now, bearing in mind the opportunity cost of the difference. Let's say that a rental unit in your area that has the same safety & convenience as your house costs $1600 per month to rent, and your mortgage is $2400. By staying in the house, you are losing that $800 month as well as interest earned on banking that money (however, right now, interest rates are negligible).

Factor in total cost of ownership too, meaning extra utilities for one or the other (sometimes houses are cheaper, sometime not), property insurance and taxes for the house (if they aren't already in escrow through your mortgage) and generic house repair stuff.

If the savings for a rental are worth more than a couple hundred a month, then I suggest you consider bailing. Start multiplying $500-1000 per month out over a year or two and decide if that extra cash is better for you than crappy credit.

Also, this is not the most ethical thing, but I do know of one couple who stopped paying their mortgage for several months, knowing they were going to give the house back at the end. They took what they would have spent in mortgage payments during that time into a savings account, and will have more than enough cash to float for the few years that their credit is lowered by the default.

Also something to consider is that we are in a time of ridiculous numbers of people defaulting. As such, a poor credit score might start to be more common among people with decent incomes, to the point where a "poor" score in 5 years is worth about the same as an "average" score today. I wouldn't count on that, but it might soften the blow of your bad credit if you default.

Answer 4

Interestingly enough, "strategic default" seems to be more common than one might think in California and there is actually a lot of information available on it, to include a calculator that breaks down the numbers for you (although affiliated with a law office).

Speaking from a purely financial standpoint, walking away only makes sense if it puts you in a better financial position than you were before while you had the mortgage. If you look at the downsides of walking away:

• Credit rating
• Exposure to fluctuations in rent
• Exposed to higher rent or hard time finding housing in short term following walking away
• Potential for employment issues in the future due to black mark on credit history
• Leaving current value of the house on the table

The issues with the credit rating are will known but you need to take into account any open lines of credit you currently have as well as any need you might have to open a line of credit in the future. If you currently have credit cards, will the rates go up after the hit?

On the housing side of things, you mortgage payment is currently a known quantity that will not change for the duration of the mortgage unless you do something to change it. However, it is fairly rare for rents to not change between years and if you want an apartment or house similar to what you currently have, you might find that the rent will fluctuate quite a bit between years and in the long run the rent might run higher than your current mortgage payment. Likewise, in the shorter term, if the landlord runs a credit check they might adjust what the rent is (or deny you the apartment) on the basis of the black mark on your history for reasons that other have mentioned.

Another item to take into account is if you need to get a job in the future. Depending upon what you do for a living this might be a non-issue; however, if you are in a position of trust, walking away from a mortgage payment will reflect negatively upon your character unless you have a very good reason for it. This can lead to a loss of employment opportunities.

Next, if you walk away from the mortgage you are walking away from the current value of the home and any future value that the home might have. If you like where you are living and aren't planning on moving to another part of the country, you are gambling that the market will not recover or that you would reach parity with what you owe by the time you need to sell the house. If you do plan on staying where you are and the house is in good repair, then in the long run you might be giving up quite a bit of money by walking away.

These are a lot of factors to take into account though so its really hard to say one way or another if a strategic default is a good idea. In the long run you might come out ahead but knowing when that date is can be difficult to calculate. Likewise, in the long run it might adversely affect you and you might come to regret the decision.

If the payments themselves are a bit too high, perhaps you can refinance or negotiate with the bank for a lower payment? If you get a better rate but keep your monthly payments the same then you might reach parity with the mortgage much faster which would also be to your advantage.

Answer 5

It's a decision that only you can make.

What are the chances that you'll want to take another loan (any loan - car, credit card, installment plan for new fridge, whatever else)?

What are the chances that with the bad credit you'll find it hard to rent a place (and in Cali it's hard to rent a place right now, believe me, I bought a place just to save on the rent)?

What are the chances that the prices will bounce and your "on-paper" loss will be recovered by the time you actually need/want to sell the house?

You have to check all these and make a wise decision considering all the pros and cons in your personal case.

Answer 6

Dan - there are other choices. What rate do you have on this mortgage? And what is the value of the home? With a bit of patience and effort, you may be able to lower your rate and save some portion of that $100k you think you can grab. There is no factual answer here. The negative will show for 7 years, and only you can determine whether that's worth it. If in that time the value comes back you may very well be in a worse position, looking to buy a new home that's now well above where it is today. It's possible the current prices are overshooting on the downside, if unemployment drops and consumer confidence returns, you may be back to break-even sooner than you think. As an aside, I find it curious that the Trumps of this world can manipulate the system, creating multiple entities, filing for bankruptcy, yet protecting his own assets, and his wealth is applauded. Yet, asking the question here so many attack you, verbally. The Donald has saved himself billions through his dealings, I don't judge you for asking this question when it comes to $100k. When Trump's net worth was negative, he should have had his property taken away, and been handed a broom.

Answer 7

To put a different spin on it, suppose you loaned someone $100K, expecting that they would pay it back, and then a little later they decided not too. They are perfectly capable of paying back the money, but just decided they didn't want to, and it seems the laws of your state said you couldn't make them. How would you feel about that?

Since this is supposed to be an answer to the question, the answer is: "only if you can't afford to repay it". That's what foreclosure is supposed to be about, not you deciding you would rather not pay your debts.

Let's not forget who pays that bill for you - every one of your bank's other customers.

EDIT:For the people decrying the moral aspect and saying "it's perfectly alright because the law says that's the punishment and I'm willing to pay it", the law also says "if you kill someone, you go to prison for life". Does that mean that someone who decides they are going to kill someone has a perfect right to do it as long as they are prepared to take the consequences?

Answer 8

This is a very personal situation of course, but if you can afford the repayments then I recommend keeping the house!. A house is a long term investment and one has to live somewhere. You probably didn't buy the house planning to sell it in 5 years so while in the short term you could suffer a loss on paper chances are things will pick up, they have to eventually. For each boom there is a bust, one for one.

Answer 9

Very few people's credit is worth $100,000. The average homeowner's credit (family of four with good to very good credit) is worth about $30,000.

This is a pure business decision. The bank knew the law when they extended the mortgage to you, and part of the amount they're charging you goes to cover the risk that you might opt to walk away.

The mortgage was an agreement between you and the bank and it specified the penalty for you walking away. Taking the agreed upon penalty for an action specifically contemplated in the agreement is also keeping the agreement.

Answer 10

The worth of a credit score (CS) is variable. If you buy your stuff outright with 100% down then your CS is worthless. If you take a loan to buy stuff then it is worth exactly what you save in interest versus a poor score. But there is also the "access" benefit of CS where loans will no longer be available to you, forcing you to rent. If you consider rent as money down teh tiolet then this could factor in. The formula for CS worth is different for everyone. Bill Gates CS is worth zero to him.

Walking away from a mortage is not the same as walking away from a loan. A mortage has collateral. There are 2 objects: the money, and the house. If you walk away the bank gets the house as a fair trade. They keep all money you put against the house to boot! Sometimes the bank PROFITS when you walk away.

So in a good market you could consider walking away to be the Moral Michael thing to do. :)

Answer 11

Many good answers here, especially that you have to consider that renting may be more expensive than you'd think. Also, keep in mind that rent is money that is completely lost. Even if the property has dropped in value, if you keep paying, you will be able to recuperate part of your mortgage payments when you sell the house. Normally this is about +-30%, but you need to calculate this yourself by dividing the expected sales price of the house by the total mortgage payments you have to make to pack back everything. So I'd say walking away only makes sense if the rents around where you want to live are much lower than (<+-30%) your mortgage payment, and stable.

In stead of walking away immediately, perhaps you can refinance your mortgage with a new one? In 2008 the rates were around 5.8%, now they are around 3.6% or so. I don't know how it goes in the USA but in my country, if the rates drop, it is relatively to do this and it can save people who refinance thousands if not more.