Improve Your Credit: Managing Foreclosures and Strategic Defaults

The time may come that you are out of alternatives and can’t make a payment. How will this affect your credit? If you’re being foreclosed on, you still may have the option to talk to the servicer and try to work things out, buy more time to come up with a solution, or at least make a more dignified exit from your home.

But timing is very important, so don’t wait!

  • Get a HUD-approved counselor involved and review loss mitigation options with your servicer. Most want to help.

  • Remain in contact with the servicer’s loss mitigation staff until you get a solution you can live with. If they don’t offer workable suggestions, ask to speak to managers and vice presidents or higher. This is not a time to stand on protocol or accept “I’m sorry” for an answer.

  • See an attorney. Ask for options. Review all the mortgage and foreclosure documents to be sure they were properly drawn and executed. The technical phrase used here is truth in lending compliance. Ask about bankruptcy options and timing so that you know all options available to you.

A strategic default is an intentional mortgage default based on a plan or strategy. Here’s an example: A person has a home whose value has fallen so far below what is owed on the mortgage that he will never realistically recover enough equity to break even on the home. Because the house will never be worth what is being paid, the homeowner stops paying the mortgage.

This option is more popular in states with nonrecourse mortgages(meaning that the house is the sole security for the mortgage loan, and the homeowner isn’t responsible for any shortage beyond what the house brings at sale).

According to the Federal Reserve, strategic default among deeply underwater borrowers (those whose home values are way below what’s owed on the mortgage) is less common than originally thought. Unemployment appears to be a bigger cause. Another consideration is that due to some local exemptions, collecting deficiencies is unlikely in some states.

Strategic default is a high-credit-damage strategy, but it may be cost-effective depending on your situation and plans involving loans or credit use in the future.

Strategic default is an unfortunate reality for many of the long-term unemployed. Thousands of homeowners are stopping payments on homes that they can no longer afford or that are deeply underwater. The argument goes: After all, this is business, and businesses routinely stop paying on debts that they can’t afford or that are worth less than they owe.

You probably have been told that you have to pay your bills, honor your obligations, and keep your promises, but many home buyers are taking a business rather than a personal approach to their homes and finances.

Most mortgages detail what happens if you don’t pay. Either you pay or your home is taken away. So the question arises: If you tell the bank to go ahead and take the house, are you meeting your obligations? From the bank’s perspective, clearly you’re not. From your family’s perspective, however, the answer may be different.

Some states require all mortgages to be nonrecourse, meaning that the lender has recourse to the defaulted property and nothing else. Also consider that the Mortgage Forgiveness Debt Relief Act prohibits the IRS from taxing as income any recourse mortgage debt forgiven up to $1 million ($2 million if filing jointly) from a foreclosure, short sale, or deed-in-lieu action until at least January 1, 2014.

Staying in a home you can’t afford can deprive your family of your precious savings, empty your retirement accounts, and eventually ruin your credit when you finally default. Many people are willing to put up with the price of any shame or guilt in order to ensure a faster recovery with more money in their bank accounts.

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