A strategic default is a calculated decision to stop paying your mortgage, even though you can afford it. This usually isn't an alternative to foreclosure, as your lender won't let you keep the house if you don't make your payments. But if the property is a second home — so you're at no risk of becoming homeless if the lender forecloses — a strategic default, in certain cases, can actually be a smart financial move.
If your second home is "under water" — worth less than the mortgage — stopping mortgage payments is like pulling out of a bad stock investment. Suppose you have a $200,000 mortgage on a vacation home that's now worth $100,000: It will be years before your payments build any equity in the house, and you probably can't sell it for enough to pay off the mortgage. If you're having trouble paying two mortgages, strategic default may make it easier to keep up with the mortgage on your primary home.
If your lender's not getting his money, sooner or later he'll foreclose. This isn't good for your credit: Foreclosure stays on your credit report for seven years and may cut your credit score by anywhere from 85 to 160 points. Worse, if the foreclosure auction doesn't pay off the mortgage, your lender may sue for a "deficiency judgment" covering the rest. Some states don't allow such suits; others only let the lender collect up to the value of the house. Anywhere else, you're on the hook for the whole amount.
One way to avoid a deficiency judgment is to negotiate a deed-in-lieu or short sale arrangement with your lender after you default. With deed-in-lieu, you simply turn over the house to your lender; in a short sale, the buyer pays less than what you owe but enough to satisfy the bank. The lender may decide these alternatives are cheaper and quicker than a foreclosure and deficiency judgment — but you can't make her accept them if she wants to sue for the deficiency. Foreclosure alternatives are as bad for your credit as actual foreclosure.
The Tax Man
When weighing the financial benefits of strategic default, keep the IRS in mind. Tax law says that money you don't pay your creditors is the same as income. If the foreclosure sale or short sale leaves you owing $40,000 on the house that you don't pay the bank, you have to pay income tax on the deficiency. Under the Mortgage Forgiveness Debt Relief Act, the mortgage on your primary home is exempt from tax, but that's not the case with a vacation home.
- New York Times: When Borrowers Default on Second Homes
- USA Today: Walking Away From Your Mortgage Has Consequences
- Nolo: Deficiency Judgments: Will You Still Owe Money After the Foreclosure
- Nolo: Short Sales and Deeds in Lieu
- MyFICO: Are the Alternatives to Foreclosure any Better as Far as My Credit Score is Concerned?
- IRS.gov: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.