What is a Strategic Default?
A strategic default is when the borrower unilaterally decides to stop making payments on a debt even when they have sufficient funds available. After careful analysis, a mortgage holder might come to the conclusion that defaulting on a loan might be more financially advantageous. Most of the time, a strategic default occurs when the mortgage is greater than the market value of the property. This situation is commonly referred to as having an “underwater” loan. But why would anyone consider a strategic default and what are the consequences involved?
While it might sound surprising or even counterproductive, a strategic mortgage default can be a powerful asset protection tactic because it can prevent the rest of your wealth from being spent on an unfavorable mortgage. Strategic defaults can be a complex topic with many significant legal and financial implications. This article will discuss important issues to consider about strategic defaults on mortgage loans and what effects it might have on a borrower’s credit record and potential legal liability.
Strategic defaults became common in the aftermath of the financial crisis of 2007, after real estate prices fell broadly across the U.S. Many regions were particularly hard hit and saw considerable losses in their local markets. Borrowers who purchased commercial or residential real estate during the tail end of the bubble years could have seen their mortgage loans greatly exceed the value of their properties. The term “jingle mail” rose in popularity to refer to the practice of people mailing house keys to the bank due to unwillingness or inability to continue paying the mortgage. Rather than waiting many years for the market to move higher, some borrowers opted to cut their losses by stopping payment on their mortgage, and let the lender take possession of the property.
Pros and Cons of Strategic Defaults
Naturally, the main benefit of a strategic default is freeing the borrower from a substantial debt obligation. While the loan does not immediately go away, the moment the borrower decides to default, he or she can use the funds originally meant for loan repayment for other purposes. The most obvious consequence will be the loss of the property used to secure the loan, but this is also likely to take some time. Particularly in the case where the lender is a large financial institution, it might take several months of delinquency before the bank takes any sort of action on the property. This can allow the borrower the marginal benefit of living in or enjoying the property “for free” during a brief period.
Perhaps unsurprisingly, a strategic default has longer term consequences beyond just the loss of the property. The defaulting borrowers can expect a dramatic loss in their credit rating, which can easily exceed one hundred points. For this reason, any credit seeking activity such as credit cards, auto loan, or loan refinancing should be taken care of beforehand. Obtaining new lines of credit and especially new mortgage loans could be next to impossible during the next two- or three-year period at least. For a Fannie Mae-backed mortgage loan, the waiting period could be seven years after a mortgage default due to the increased requirements for these types of loans.
Non-Recourse vs. Recourse Loans
What about the rest of the borrower’s assets? Could a bank sue the borrower who defaults on a mortgage for the full repayment of the loan? While this will depend on the specific terms of each individual loan, fortunately the answer is typically no. Mortgage loans in the U.S. are often structured as “non-recourse” loans, which means the lender is not allowed to pursue anything other than the collateral in the event of non-payment. If a borrower defaults on a nonrecourse home loan, the bank can only foreclose on that particular house, even if the borrower has a different mortgage on another property that he is not defaulting on. This makes the financial downside of a strategic default both limited and relatively easy to figure out for the borrower at least in many cases.
In other instances, if a mortgage is structured as a recourse loan, then the lender could be entitled to go after the borrower’s other assets even after taking possession of the property subject to the loan. If the property is foreclosed on and sold at auction, but the proceeds are not sufficient to cover the loan amount, then the lender could be entitled to a deficiency judgment to cover the difference. In this situation most of the borrower’s net worth could be at risk. Recourse loans have been banned in the following states: Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington. It is important to understand the terms of your mortgage loan and consult an attorney before considering a strategic default.
What Happens During a Strategic Default?
Failing to make timely payments on the loan is just the first step towards a strategic default. Eventually, if nothing else is done by the borrower, then the secured lender will foreclose on the property. This is not necessarily the best option. In many cases, attempting a short sale might be a better option. A short sale is less damaging to the borrower’s credit than an outright default; and its effects can drop off from their credit record in about two years. However, a short sale needs to be approved by the lender and this can be next to impossible in the case of a strategic default because the level of economic hardship is not high enough.
The best-case scenario usually is a favorable negotiation with the lender in which they agree to release the borrower from the loan in exchange of a fee. The lender of course will take possession of the property as well. This arrangement tries to soften the economic blow of the default for the lender while at the same time releasing the borrower from a heavy financial burden. Of course, not all lenders might be willing to negotiate. Smaller institutions such as hard money lenders are usually more comfortable with taking possession of a property, while banks with larger books of loans generally only take properties as a last resort, leaving more room for a possible negotiation.
The Ethics of a Strategic Default
Discussions around strategic defaults often cover the perceived ethical considerations of failing to pay on a loan. Some people might view a strategic default as a disreputable or disingenuous strategy to get out of debt. Other people might feel a strategic default is wrong because it represents a break of a written contract they signed and committed to. While blaming the borrower might be the first reflex, we could just as easily shift the blame to the banks for lending too much money while failing to consider the possibility of having insufficient collateral on hand if the property were to fall in value. At least in the case of the 2008-2009 real estate bubble, predatory lending practices played a significant role, and many borrowers were taken advantage of with what they thought were tremendous financing opportunities.
It is true that a strategic default is probably not what either party wanted when originally entering into the loan agreement, more often than not, it is greater economic factors that push a borrower towards default, whether voluntary or not. As unforeseen factors enter the picture, such as the loss of value of the property, it is normal to expect the wishes of the parties to change. A borrower who was happy to purchase a property several years ago might be seriously regretting the transaction today. This is more than just buyer’s remorse; it could be a significant or catastrophic financial loss. In these cases, it seems unreasonable to keep the borrower forced to pay a loan when the economic realities have changed drastically.
Most mortgages are generated by professional financial companies, and in theory any loan issued should be a willing transaction between both parties. For a large financial company, a default on a loan can hardly be a shocking and unforeseen event. In fact, many loan agreements contain detailed clauses regarding non-payment, and while this might not be directly communicated to the borrower, the cost of obtaining a loan contains a risk premium that is included in the interest rate. For these reasons, you should not feel that strategic defaults entail cheating or dishonest dealing with your lender.
As attorneys, we are often forced by our professional responsibilities to put aside our feelings and do what is best for our clients. Regardless of personal feelings and moral considerations, the truth is a strategic default is sometimes the best legal and financial decision and should not be overlooked. It is rarely a happy decision, but a as with any major financial and legal decision, a strategic default should be a determined by a well-informed cost benefit analysis first and emotional considerations second.
Strategic Defaults on the Rise Again?
With the recent and dramatic rise in interest rates, the financial and real estate markets are starting to feel the pressure. Hopefully, the economy will remain strong, and we will not be faced with a repeat of 2007. Even with a mild downturn, it is possible for property values to fall well below peak purchase prices. In that case, strategic mortgage defaults might once again rise in popularity as a debt relief tactic. With the enduring acceptance of work from home policies with many major employers around the country, this time around it might be commercial and office space real estate that bears the brunt of the slowdown. That remains to be seen.
A strategic default might seem like a drastic measure, and it often is. Nobody likes seeing their property taken by a lender due to nonpayment, but it certain instances it might be better than the alternatives. We hope you are not in a situation where a strategic default is an option, but if so then we may be able to help. If you would like to learn more about strategic defaults and other legal ways to protect your wealth, contact Blake Harris Law to speak with an asset protection attorney today. At Blake Harris Law, we focus exclusively on asset protection, including offshore banking and trusts.
