Doing the Math on a Strategic Default

The decision to strategically default on a home is difficult. Most clients with whom I meet debate the issue for months. Ethical and moral issues aside, the overriding factor should be a financial one:

Does it make more sense to continue to debt service the mortgage in the hopes of a quick market recovery or to sell now?

Generally speaking, if a property is more than 15% underwater and if the rent you collect does not cover your mortgage payment, a short sale may be your best option. And if you do consider short selling, here are some tips:

First, as long as you are current on your mortgage, your lender will not allow you to short sell. Should you strategically default on your mortgage so that your lender will approve a short sale, not only will your credit score take a substantial hit, you may still be denied if you cannot show a hardship. Note: a reduction of income, including the loss of rental income, is considered a hardship…

That being said, mortgage lenders and mortgage insurance companies, rather than denying a short sale on a defaulted loan, may approve one if the borrower agrees to financially contribute to the sale.

To determine if the contribution from your bank is worth getting out from underneath the over-leveraged investment home, follow these steps:

1) Take the amount you subsidize the property each month, including your mortgage payment (principal, interest, taxes, insurance) as well as any maintenance fees, HOA fees, etc. Multiply that by the number of months you think it will take for your home to be worth what you owe on it. To estimate how long it will take for your home to appreciate to what you owe, assume a 2% yearly appreciation and multiply the home’s current value by 102% each year until you reach what you owe.

2) Now, assuming you will be asked to contribute to a short sale, expect to pay approximately 20% of the shorted amount, or deficiency, in exchange for a release of any further debt obligation.

3) Compare these two amounts: the cost of subsidizing your mortgage and the cost to sell. This should give you an idea of which option makes more sense: carrying the property or liquidating it.

Here is a real life example:

A client is considering short selling his rental home.

The property’s market value is $220,000, and he owes $285,000. This puts him upside down by $65,000, or 23%. Assuming a 2% yearly appreciation, it will take 14 years for his home to be worth what he owes.

His mortgage payment (PITI) and HOA fee total $2,016, and he collects $1,350 in rent, so he is subsidizing his mortgage to the tune of $666 per month. Fourteen years of subsidizing $666 per month will cost him $111,888. This does not take in to consideration the cost of any repairs he will incur over the years or the fluctuations of rental-rate income, variables this exercise does not factor.

He has been approved for a short sale but must contribute $17,900 at closing. Currently, I am negotiating for a reduced settlement amount, but that’s besides the point. $17,900 is based upon his lender writing off approximately $85,000 (the mortgage payoff minus the net proceeds from the result of the short sale).

So, the options to him are to liquidate the home for about $18k or hang on to it at the expense of nearly $120k.

Certainly, there are other factors to consider: Yes, his credit will be impacted, and selling the home will cost him the tax advantage of deducting the interest he pays on the mortgage, and he may have to pay some taxes on the forgiven amount since he is not selling a primary residence (although he may mitigate this if he can show insolvency. See the Mortgage Forgiveness Debt Relief Act ).

It took several months for my client to come to this conclusion and looking at the numbers, for him, the decision to short sell became clear. If you would like a review of your unique situation, please contact me for a free consultation.