The higher costs of strategic mortgage default
Lenders look a lot less favorably on those who walked away from their homes even though they could afford to pay.
This post comes from Amy Hoak at partner site MarketWatch.
Homeowners considering strategic default need to know this before taking the leap: The fact that you could have continued paying your mortgage, but chose not to, could mean you'll face harsher consequences than those who defaulted out of hardship.
Defaulting on a mortgage generally means a severe hit to your credit score, said Joanne Gaskin, FICO's director of mortgage markets. And that's the same whether you lost your job and couldn't afford the payments or if you decided your mortgage was so far "underwater" that you stopped paying and eventually ended up in foreclosure.
Someone with a 720 FICO score could move into the 580s after a mortgage loan default, she said. It could take seven years to get back to the starting score, "assuming all other trade lines were paid as agreed."
But here's the thing: When you're buying another home or even renting one, lenders and landlords may be more discriminating about the type of default you have on your record, she said.
And they don't take kindly to strategic defaulters.
"Credit remains very tight across the board, so lenders, landlords are looking for pretty pristine credit," she said. "There's leeway somewhere if someone had an explainable life event, a one-time blemish on their record that is pretty explainable."
"Within the mortgage business, no one is thinking that strategic default is explainable," Gaskin added.
The price you'll pay
Fannie Mae, for example, has said it's not willing to guarantee or purchase a loan from someone who has strategically defaulted for seven years after the event, a time period that is "much more stringent than someone who was truly distressed," she said. Someone who had a life event that impaired their ability to make payments might be able to enter the mortgage market again more easily after two or three years of demonstrating good credit management skills, she said.
Think you'll rent instead? That also may not be as easy as you think.
"Landlords that make inquiry into credit history may be disinclined to rent to a strategic defaulter or may offer less favorable terms than to a consumer with a strong credit history," Gaskin said. With rental markets becoming more competitive these days, landlords have more applicants to choose from -- allowing them to pick renters with the best credit histories.
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Meanwhile, a lower credit score will cost you when it comes to insurance, too. "Roughly 95% of all auto insurance policies and close to 90% of all homeowners policies are awarded today based on credit-based insurance scores," she said. Cellphone companies also check consumers' credit before issuing them a phone, she said.
There are some telltale signs of strategic defaulters: They typically have higher credit scores before defaulting, and have less utilization of their credit lines, according to FICO. They also often have lived in the home for a shorter amount of time, so they have less attachment to it.
FICO has come up with a way for lenders to identify potential strategic defaulters before they become delinquent -- presumably to work with those borrowers and dissuade them from walking away.
"A foreclosure walk-away is not good for anyone -- the neighborhood, the consumer, the investor. The more that we see this activity, the more we will see a downward cycle in the housing market," Gaskin said.
Fewer strategic defaults ahead?
Yet despite all the buzz about this concept, the percentage of strategic defaulters in the overall number of delinquent borrowers hasn't risen over the past year, according to FICO.
Results of another recent report indicated that the number of defaults believed to be strategic dropped to 30% in March, down from 37% in January, according to the Chicago Booth/Kellogg School Financial Trust Index, released by the Kellogg School of Management at Northwestern University and the University of Chicago Booth School of Business.
"This change might be due to the increase in the perceived probability that a lender will go after a strategic defaulter," said Paola Sapienza, professor of finance at Kellogg, in a news release. Laws vary by state, but in many parts of the country, lenders are allowed to file deficiency judgments for the difference between the mortgage balance owed and the amount the lender sold the foreclosure for.
Strategic default peaked in September, said Luigi Zingales, professor of entrepreneurship and finance at the Booth School.
What happens in the months ahead depends on the path of home prices; when prices stabilize and begin to rise again, the incidence of strategic default should drop, he said. Since price trends vary by location, borrowers in some parts of the country will see better days sooner than others, he added.
Still, one of the biggest factors that cause someone to strategically default is being underwater on a mortgage -- and there remain many people who owe more on their mortgage than their home is now worth. Currently, 27% of mortgages are underwater, Gaskin said.
In addition, the overall number of at-risk borrowers remains elevated, said Laurie Goodman, senior managing director of Amherst Securities. She estimates that more than 11.5 million borrowers are in danger of losing their homes -- if government policy doesn't change to reduce the number. That's one out of five homes in the U.S.
Policy changes needed
She thinks policymakers need to think of default as an economic issue, not a moral one, she said in a presentation, adding that for many borrowers who are defaulting on their mortgages, the move is a rational choice. Policy should increase the cost of default while increasing the benefit of people remaining in their homes making payments, she said.
Goodman's other suggestions for dealing with the massive amount of negative equity in the country include more principal forgiveness on underwater mortgages and better handling of second liens that can be a roadblock in helping borrowers get modifications. And if a borrower accepts a principal reduction, there should be well-defined consequences, including, possibly, a hit to his or her credit score, she said.
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