Walking from Underwater Home May Be Good Option for Many According to Brent White

Brent White, a Professor at the University of Arizona College of Law has written a provocative paper which makes the case that for many homeowners walking away from their underwater home is the best long-term economic decision. He argues that societal pressure and the fear of ruined credit force many homeowners to stay put, even though doing so is bad for their personal finances and long-term wealth.

Brent White, a Professor at the University of Arizona College of Law has written a provocative paper entitled Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis. The paper makes the case that for many homeowners walking away from their underwater home is the best long-term economic decision. He argues that societal pressure and the fear of ruined credit force many homeowners to stay put, even though doing so is bad for their personal finances and long-term wealth and only good for the banks.

Here's an example he used to make his point:

Consider, for example, Sam and Chris, a young professional couple with two small children, who stretched to buy their first home - an average 3 bedroom, 1380 square foot house in Salinas, California – for $585,000 in January of 2006.

Unfortunately for Sam and Chris, the housing market began to collapse in 2007. Though they still owe about $560,000 on their home, which is just under 31% of their gross monthly income, and within the payment-to-income ratio considered “affordable” by most lenders. However, after paying for taxes, health insurance, student loans, childcare, automobiles, food, and other necessities, Sam and Chris do well to break even each month. At the time they bought their home, they were not overly concerned about this - as they saw their mortgage payment itself as an investment in their own and their children’s futures.

It is now only worth $187,000. A similar house around the corner from Sam and Chris recently listed for $179,000, which, with a modest 5% down, would translate to a total monthly payment of less than $1200 per month – as compared to the $4300 that they currently pay. They could rent a similar house in the neighborhood for about $1000.

Assuming they intend to stay in their home ten years, Sam and Chris would save approximately $340,000 by walking away, including a monthly savings of at least $1700 on rent verses mortgage payments, even after factoring in the mortgage interest tax reduction. The financial gain for Sam and Chris from walking away would be even more substantial if they took their monthly savings and put it into an investment account. If they stay in their home on the other hand, it will take Sam and Chris over 60 years just to recover their equity – assuming, of course, that they live that long, the market in Salinas has indeed hit bottom, and their home appreciates at the historical appreciation rate of 3.5%.

It's important to note that he is talking about people who can afford to stay in their underwater homes. They are not forced out but remaining in their homes is currently a bad financial situation. Economically, his point is valid. There are many homeowners who will never recoup the investment made in their homes in their lifetime. In addition, they will be paying above market monthly payments while they live in those homes.

Yet, the number of people bailing on their mortgages is small. Although more than 32% of U.S. homeowners were underwater on their mortgages by the end of the second quarter of 2009, the strategic default rate was roughly 3%. He defines the strategic default rate as people to voluntarily decided to leave their homes because they are underwater and are now money sinks and bad investments. That contrasts with people who are forced into foreclosure because of a job loss, divorce, medical problem, etc.

Why aren't more people bailing? Most reading this intuitively know the answer. According ot his research, the reasons people don't give up their homes, even when it makes financial sense to do so are:

1. The social stigma or failing and being forced out of your home.

2. The fear of a ruined credit score and all that it entails.

He believes the social stigma has been reifornced by the government and the banks to force people to stay, even when it is against their best self-interest. Those who lose their homes are labeled as deadbeats, dreggs of society, irresponsible, etc. The question is, what is more irresponsible, staying in a home that is making you poor, of hanging on by your fingernails to pay the bank that approved the loan in the first place?

In his opinion, both the bank and the homeowner have a joint responsibility, especially since the sales price was based on a bank assessment and on bank products that minimized down payments and increased risk. This seems reasonable to me. Yet, the homeowner is being asked to shoulder 100% of financial responsibility for a loan jointly made.

Which brings us to the second reason that homeowners stay in their homes: fear of ruining their credit score. According to his research, this fear is somewhat overblown. Credit scores generally recover within 2-4 years after a foreclosure. If a homeowner prepares strategically for the foreclosure by making big ticket purchases in advance, then the impact can be largely minimized. And the FHA offers loans to homeowners who have been through a foreclosure after four years.

In his opinion a foreclosure shouldn't even appear on a credit score because a mortgage loan is a secured loan. That is, the contract stipulates that a homeowner can stop paying and walk away and the bank will receive the home. Giving up the home is the contractual penalty, not having a destroyed credit score. The credit score destruction is not in a mortgage contract and is a way that banks have shifted mortgage contracts in their favor. He also believes that by eliminating the credit score penalty, banks will have a stronger incentive to renegotiate the mortgage they entered into, and work in a partnership to avoid foreclsoure.

Should Banks or  Homeowners Pay?

In the end, his argument is one of who should pay for an entire culture that was so captivated by housing that economic realities were ignored. Individuals were blinded by the bigger-and-bigger homes they could suddenly afford. Banks were captivated by the profits they were generating by writing, packaging, and selling mortgages and mortgage backed securities on clearly inflated home values.

Right now, most homeowners are bearing the burden for these joint decisions. The banks have received hundreds of billions in Federal money (our money) and because of that are now making record profits. Homeowners are struggling to make payments on underwater homes. Homeowners are subsidizing the banks on two fronts: by staying in these underwater homes, and by paying taxes which are being used to prop up the banks.

You can decide which is more moral.

He believes that best option is for banks to work with borrowers to reduce the mortgage note, not the monthly payment. That helps to readjust prices to these new economic times and creates a solution for the two parties who jointly entered into the agreement in the first place.

I also believe banks should require higher down payments. That would insure that only qualified buyers could afford a home and give the homeowner more skin in the game. In many ways, banks have created the perfect condition for homeowners to walk with 0% downpayment mortgaqes.

So, what do you think? Would you walk if your house was 20% underwater with no prospect of seeing it recover anytime soon?

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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Comments

  • Ricardo

    December 02, 2009

    I wouldn't walk away. I made an obligation to pay the loan and I'll do my best to do it. I made the mistake of buying a home at an inflated price. The bank was an enabler but didn't force me to make the loan.

    It comes down to how you meet the obligations you make.

  • Why Pay?

    December 02, 2009

    I haven't seen mortgages discussed this way and it makes a lot of sense. If I was far underwater I'd probably walk. I have no loyalty to the banks. They assess every fee they can and then expect me to stay in a house that's gone down in value. Is your loyalty to a bank or to your family? For me, family wins out every time.

    In terms of obligation, banks are constantly breaking their obligations. The only obligation you have in a mortgage is to pay it or give up the house. That's why a house is assessed as collateral. This is a financial transaction, not a personal or moral one. Do you think banks would hesitate to break their contracts if it suited them? Companies do not hesitate to break their contracts.

  • Shel

    December 02, 2009

    When you lend money to someone you expect them to pay. You don't want to have to get you collateral. In the olden days, they'd lock you in a debtors prison if you couldn't meet your obligation.

  • D.Ora

    December 02, 2009

    Go for it.

  • Sheila

    December 02, 2009

    Please, what about responsibility. The banks aren't responsible but we're supposed to be. They're killing our savings rates and hiking up credit card fees but we need to stay in an underwater house. I understand personal responsibility but isn't that taking it a bit far. If I'm going to fall on my sword it has to be for a better cause than a bunch of bankers and their shareholders. Even if that shareholder is ultimately some little old lady looking for her quarterly dividend.

  • David Cohn

    December 02, 2009

    Personal responsibility is dead if people listen to this article. We have become a socialist state in every way.

  • Samuel

    December 06, 2009

    With the irresponsible bank behaviors, we should be handing off all the underwater homes back to them.
    Force the banks to pay property taxes else liquidate and auction the property, because they are not accepting short sales.

    Life, liberty and the pursuit of happiness was meant for all citizens, not just for irresponsible bankers and corrupt politicians.
    Let's take our country back. Make it again a country For the people, By the people.
    Don't support Bailouts and Bonuses meant Only for the Bankers and Politicians at the expense of the people.

  • chris

    December 18, 2009

    Please, by providing loans to anyone with a pulse the banks created a huge demand for housing and therefore forced the price of a house to levels never seen before. Any average person who bought a house during this time and did not understand that their home price was overinflated by a false demand created by the banks was a sitting duck waiting for financial ruin.

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