If you have a mortgage for an amount greater than the value of your property, what do you do? If you're the owner of the largest residential property in Manhattan, you walk away, leave the mess to your creditors and go on about your business. That's exactly what happened when Tishman Speyer abandoned the 11,000 unit Stuyvesant Town and Peter Cooper Village in Manhattan in 2010. It was one of the largest defaults in history – and the company remained in business. Tishman was merely following in the path of many commercial real estate enterprises that had gone before it.
Unfortunately, if you're a residential mortgage holder, walking away isn't so clean or easy. But this may still surprise you: mathematically speaking, walking away can sometimes be the most prudent choice.
Run Your Life Like a Business
Prior to the national housing bubble of the late 2000s, real estate prices could generally be counted on to rise over time. A few regional pockets would decline in value from time to time, but on a national basis, good homes in good neighborhoods gained value over time. In 2008 and 2009, they plunged, posting double-digit declines in value. As 2009 came to a close and 2010 opened, some 25% of all mortgages nationwide were underwater, meaning the amount owed on the mortgages was greater than the value of the homes. At this point, the previously unthinkable occurred: Borrowers who could still afford to make their mortgage payments decided not to.
Some experts suggest that walking away from a mortgage is a sound financial move any time a borrower could rent a similar dwelling for less than the cost of the mortgage. Add in the fact that many people were underwater to the tune of 25% or more and faced rising interest rates on adjustable-rate mortgages and suddenly the incentive to walk away looked more like an incentive to run. (When a housing crisis strikes, the big winners are often the renters.
Financially, comparing the cost of rent to the cost of a mortgage is a simple calculation. One tool you can use to estimate your monthly mortgage payments is a mortgage calculator. Determining the amount of time it will take your home to recover its lost value is a slightly more complex effort. Using a 5% yearly increase in value will provide a ballpark figure based on national averages. A little research can help you make adjustments for regional and local markets. Consider an example:
- Original price: $200,000
- Today's value: $150,000
- Loss in value: 25%
If real estate values climb at an average of 5% per year, it will take six years for this home to reach its sales price. This gets the owner to break even, but there is no profit to show and the owner has paid interest on the loan every year. If prices fall another 10%, recovery will take even longer. (Home price appreciation is not assured.
- Original price: $200,000
- Value after 25% decline: $150,000
- Value after another 10% decline: $135,000
The recovery time is now just over eight years.
Ways to Walk
Three of the most common methods of walking away from a mortgage include holding a short sale, voluntary foreclosure and involuntary foreclosure. A short sale occurs when the borrower sells a property for less than the amount due on the mortgage. The buyer of the property is a third party (not the bank), and all proceeds from the sale go to the lender. The lender either forgives the difference or gets a judgment against the borrower requiring payment for all or part of the difference between the sale price and the original value of the mortgage.
Not all lenders will agree to a short sale, but if they will, it provides an alternative to foreclosure.
In a voluntary foreclosure, the homeowner turns the property over to the lender voluntarily. To arrange a voluntary foreclosure, talk to your bank and make arrangements to deliver the keys to the property. While this process will have a negative impact on the homeowner's credit rating, he or she won't have to make additional payments on the mortgage.
Involuntary foreclosure is initiated by the lender for nonpayment. The lender uses the legal system to take possession of the property. While the homeowner often gets to live in the property free of charge for months while the foreclosure process takes place, the lender will be making an active effort to collect on the debt and, in the end, the homeowner will be evicted.
The Double Standard
Companies routinely cut their staffing levels and "restructure" their debt, hurting and often destroying the suppliers they don't pay. Wall Street cheers and stock prices rise, yet when an individual attempts to make the same moves, the legal system kicks into action to protect the lender's profits and the homeowner's friends question the homeowner's morality. While only a minority of banks will agree to short-sale for a homeowner, all of them are willing to foreclose.
A level playing field would mean that homeowners should feel no worse about walking away than businesses do when they default or foreclose on properties. Since the field is not level, borrowers need to be willing to accept the consequences of their actions if they walk away. These consequences could include damaged credit, harassment by collection agencies and difficulty in obtaining credit for years. The social stigma is also worth considering.
The Bottom Line
After completing your research, if walking away is your best option, be prepared. To make sure you have a place to live, buy a new, smaller home or rent an apartment before you walk away from your current home. Buy a car and other big-ticket items while your credit rating is still good, and set aside some cash to help smooth the transition.