A strategic default is the decision by a borrower to stop making payments (i.e. default) on a debt despite having the financial ability to make the payments.
This is particularly associated with residential and commercial mortgages, in which case it usually occurs after a substantial drop in the house’s price such that the debt owed is (considerably) greater than the value of the property – the property negative equity or “underwater” – and is expected to remain so for the foreseeable future, such as following the bursting of a real estate bubble. Such borrowers are called “walkaways.”
Prevalence post-housing bubble
Distinguished economists Paul Krugman and Hal Varian have acknowledged that strategic default will be an inevitable result of the collapse of the finance and property bubble of the era following 2006. They also note that this is one of the few ways of freeing people from the burden of mortgage debt. Once free of the mortgage debtors are free to use their income for other expenditures.
A study in September 2009 from the credit reporting agency Experian and consulting outfit Oliver Wyman estimated that close to a fifth of troubled mortgages in the U.S. involved borrowers who were strategically defaulting
Effects vary by jurisdiction; different countries and different states in the United States treat default on mortgage debt differently, notably distinguishing whether it is recourse debt and non-recourse debt, meaning whether the mortgage lender can pursue claims against the defaulted debtor. Further, mortgage refinancing may be treated differently from an original, un-refinanced mortgage, and mortgages on second homes may be treated differently from mortgages on primary residences.
The borrower after deciding to not make payments any more can live (free of the costs of payment or rent) until the lender forecloses which may take from several months to years. A borrower may use this time to extinguish or negotiate other debt. Mortgage lenders may negotiate with defaulting borrowers to assure maintenance and occupancy of the property until the lender can take title and market the house, and may provide the defaulting borrower with greater than the minimum legal notice to quit (which can be as little as three days) and may even agree to pay a fee to leave the home in pristine condition.
Foreclosure of the borrower’s house will result in a negative entry on the borrower’s credit rating, possibly making obtaining loans in the future more difficult or more expensive for the borrower. With otherwise good credit a new mortgage will be denied until up to 7 years have passed since the actual date of foreclosure.
The difference between the value of the property at the time of foreclosure and the amount of the note (assuming the note is larger) is considered by the IRS as “debt forgiven” and is “income” subject to income tax. For a short period ending at the end of December 2012 due to the Mortgage Forgiveness Debt Relief Act of 2007, this “phantom income” will not be subject to tax. California has just recently passed legislation that follows law in this regard. Insolvency is also an exception and should be discharged with your tax advisor.
Some ethicist have questioned the morality of strategic default, arguing that one has a duty to make payments on debt if one is able.Others argue that there is no such moral duty, a loan being a contract between consenting adults, and noting that financial investors routinely default on non-recourse loans that have negative equity.
Some argue further that there is a moral duty to strategically default, and that one should make such decisions based on one’s financial interest “unclouded by unnecessary guilt or shame”, as lenders who do not modify mortgages do the same, “seeking to maximize profits or minimize losses irrespective of concerns of morality or social responsibility,”or more bluntly stating that “The economy is fundamentally amoral.
Further, obligations to honor a contract are balanced by obligations to oneself and one’s family, the latter speaking in favor of strategic default, some arguing “You need to put yourself and your family’s finances first,”while one also has obligations to a community, which may be damaged by default.
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