...by Anthony Buono
A strategic default in terms of home ownership is the decision by a homeowner to stop making mortgage payments (to default) on their debt despite having the financial ability to make the payments.
This is particularly associated with residential mortgages. It usually occurs after a substantial drop in the house's price when the debt owed is much greater than the value of the property, meaning negative equity or underwater, and is expected to remain so for the foreseeable future.
Homeowners who walk away in strategic defaults are not necessarily the ones most 'underwater.'
Credit scores are designed to predict the risk of default. But when it comes to strategic default -- which is when people who can afford to pay their mortgages don't, usually because their homes are worth less than their loans -- analysts have noticed a reverse phenomenon: Good credit scores can indicate a higher likelihood that a homeowner will voluntarily bail on a home loan.
Today, somewhere around one in three mortgage defaults is strategic.
"People who make the decision to strategically default tend to be more savvy," said Andrew Jennings, the chief analytics officer for Fair Isaac, the company that created the leading FICO credit score. "Most of the people who walk away from a mortgage are saying, 'This is not a contract that makes sense anymore.'"
FICO analysts looked at a population of borrowers who started out current on all their bills but wound up 90 days or more behind on their mortgages.
The people who stayed current on their other bills but stopped paying their mortgages had better initial credit scores and lower credit balances, and were less likely to have gone over their limits -- all signs of responsible money management.
Intriguingly, one factor that wasn't a strong predictor of strategic default was how far "underwater" these homeowners were. What mattered far more was the future trajectory of home prices.
Another point: research indicated that 40% of strategic defaulters lived in "recourse" states, where they could face lawsuits over debts that remained after foreclosure. It's not clear whether defaulters didn't understand the risks or whether they had bet that their lenders wouldn't come after them.
“We feel that people take this action without fully understanding the consequences," Jennings said. The message coming from them is that if enough people take this action, there is no way the banks are going to come after us, and even if they do, we can declare bankruptcy."
Strategic default dumps the traditional "payment hierarchy" on its head. In the past, lenders could count on people skipping other payments first before they reneged on their mortgages. And, the trend seems to be growing. A study at the University of Chicago found that 35% of mortgage defaults in the U.S. were strategic in September 2010, compared with 26% in March 2009.
If you're thinking about skipping out on your mortgage, here's what you need to keep in mind:
- The foreclosure process varies by state and by lender. Don't count on other people's experiences to predict your own.
- Your risk varies. Some states prohibit lenders from suing you for mortgage balances you owe on a primary residence. Massachusetts is NOT one of those states. Massachusetts allows the lawsuits. Before you stop paying, talk to a bankruptcy attorney who is familiar with the credit and real-estate laws in your state as well as industry practices.
- Understand what a foreclosure does to your credit. The higher your credit scores, the longer they will take to heal.
Original article on MSN money