There are times when it can be a prudent choice
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Reviewed by Lea D. UraduFact checked by Suzanne KvilhaugReviewed by Lea D. UraduFact checked by Suzanne Kvilhaug
If you owe more on your mortgage than your home is currently worth, what do you do? If you’re a residential mortgage holder, it may surprise you to hear this advice: Mathematically speaking, walking away can sometimes be the most prudent choice. For instance, if you’re underwater on your mortgage and interest rates are rising, you might be better off walking away from your mortgage and renting. This is especially true if you have an adjustable-rate mortgage.
Key Takeaways
- Sometimes, walking away from a residential mortgage is the best option.
- During the Great Recession, many homeowners—even those with enough income to cover their mortgages—decided to walk away after their homes lost value.
- Some experts claim that it can make sense to walk away from a mortgage anytime it is possible to rent a similar place for less than the mortgage payment.
- Holders of adjustable-rate mortgages (ARMs) who own homes that have lost value are more likely to abandon their mortgages during periods of rising interest rates.
- If walking away is the best option, be prepared and have a plan for your next place to live.
When Walking Away Makes Sense
Prior to the national housing bubble of the late 2000s, real estate prices could generally be counted on to increase over time. While a few geographical regions would occasionally see declining values, on a national basis, homes gained in value over time, which was the long-term trend in the United States.
However, in 2008 and 2009, property values plunged (at times, posting double-digit declines in value). As 2009 came to a close and the year 2010 opened, 23.1% of all mortgages nationwide were underwater—the amount owed on the mortgages was greater than the value of the homes. At that point, what was previously unthinkable to some actually occurred: Borrowers who could still afford to make their mortgage payments decided not to do so.
If you can rent a similar-type house for less than the cost of the mortgage, some experts suggest that walking away from a house is a sound financial move. In a scenario where you are underwater on your mortgage and facing rising interest rates (due to an adjustable-rate mortgages (ARMs)), the incentive to walk away may be even more appealing. (When a housing crisis strikes, the big winners are often renters.)
Calculating the Cost of Walking Away From a Mortgage
The calculation for comparing the cost of rent to the cost of a mortgage is a simple calculation. One tool to estimate your monthly mortgage payments is a mortgage calculator.
Determining how long it will take for your home value to recover is a slightly more complex effort. Using a 5% yearly increase in value will provide a ballpark figure based on national averages. A little research can help you make adjustments for regional and local markets. Consider an example:
- Original price: $200,000
- Today’s value: $150,000
- Loss in value: 25%
| Year | Beginning Value | +5% |
| 1 | $150,000 | $157,500 |
| 2 | $157,500 | $165,375 |
| 3 | $165.375 | $173,643 |
| 4 | $173.643 | $182,325 |
| 5 | $182,325 | $191,442 |
| 6 | $191,442 | $201,014 |
If real estate values climb at an average of 5% per year, it will take six years for this home to reach its sales price. This gets the owner to a break-even level—but there’s no profit to show (and the owner has paid interest on the loan every year). If prices fall another 10%, recovery will take even longer. (Obviously, home price appreciation isn’t assured.)
- Original price: $200,000
- Value after 25% decline: $150,000
- Value after another 10% decline: $135,000
| Year | Beginning Value | +5% |
| 1 | $135,000 | $141,750 |
| 2 | $141,750 | $148,837 |
| 3 | $148,837 | $156,279 |
| 4 | $156,279 | $164,093 |
| 5 | $164,093 | $172,297 |
| 6 | $172,297 | $180,912 |
| 7 | $180,912 | $189,958 |
| 8 | $189,958 | $199,456 |
| 9 | $199,456 | $209,429 |
The recovery time is now more than eight years.
Methods for Getting Out of a Mortgage
Three of the most common methods of walking away from a mortgage are a short sale, a voluntary foreclosure, and an involuntary foreclosure. A short sale occurs when the borrower sells a property for less than the amount due on the mortgage. The buyer of the property is a third party (not the bank), and all proceeds from the sale go to the mortgage lender. The lender either forgives the difference or gets a judgment against the borrower. Then, the borrower is required to complete the payment of all—or part of—the difference between the sale price and the original value of the mortgage.
Important
Not all lenders will agree to a short sale, but if they will, the short sale provides an alternative to foreclosure.
In a voluntary foreclosure, the homeowner willingly turns the property over to the lender. To arrange a voluntary foreclosure, talk to your bank and make arrangements to deliver the keys to the property. While this process will hurt a homeowner’s credit rating, additional payments on the mortgage are no longer required.
Involuntary foreclosure is initiated by the lender for non-payment. The lender uses the legal system to take possession of the property. While the homeowner is often allowed to live in the property for months (free of charge) while the foreclosure process takes place, the lender will be making an active effort to collect on the debt, and, in the end, the homeowner will be evicted.
The Double Standard
Companies routinely cut their staffing levels and restructure their debt. This can hurt (and sometimes destroy) the suppliers they don’t pay. However, these are considered “good” business moves; stock prices for these companies usually rise in the aftermath.
But, when an individual homeowner attempts to make the same decision, the legal system is set up to protect the lender’s profits. While only a minority of banks will agree to a short sale for a homeowner, all of them are willing to foreclose.
Warning
Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau (CFPB) or with the U.S. Department of Housing and Urban Development (HUD).
A level playing field for consumers and businesses would mean that homeowners should feel no remorse about walking away from a loan compared to businesses that default or have properties foreclosed. As the field is not level, borrowers who walk away need to be willing to accept the consequences, which can include damaged credit, harassment by collection agencies, and difficulty obtaining credit for years.
When Should You Walk Away From a House?
If your home has lost significant value and you’re now paying more than the home is worth, some experts recommend walking away and renting a similar home for less.
What Are the Consequences of Walking Away From Your Mortgage?
Homeowners who walk away from their mortgages can face harassment from collection agencies that try to collect mortgage payments. Plus, not making payments will damage their credit, making it hard to get credit down the road.
How Do You Get Out of a Mortgage?
You could put the home up for a short sale, voluntarily turn over the home to the bank, or let an involuntary foreclosure play out.
The Bottom Line
After completing your research, if walking away is your best option, be prepared. To make sure you have a place to live, buy a new, smaller home—or rent an apartment—before you walk away from your current home. Purchase a car and any other big-ticket items that require financing before your credit score is downgraded, and set aside some cash to help smooth the transition.
Read the original article on Investopedia.