Strategic Default on Mortgages - Is it morally wrong or a smart move?

One of the latest and hottest debates in the financial world is the growing trend of strategic defaults on mortgages. Those who participate in this choice are people who have the ability to pay their mortgage, have a stellar credit rating and abruptly choose to walk away from their home payment responsibility. This is not a new phenomenon, and happens when the value of the home is significantly less than the amount owing. These people often continue to live in the home, rent free, until the red tape overload of foreclosure at their lending institution catches up with them.

So why do they do it?

A survey was done by the national credit bureau, Experian, and Oliver Wyman, a consulting company on the recent increase in strategic default. By having the ability to access credit files over an extended time span, they discovered certain patterns with homeowners. Two interesting facts came to light:

– The number of strategic defaults surpassed all expectations, with 558,000 occurrences in 2008, which is more than double that of 2007.

– Homeowners who take the path of strategic default on their mortgage go from having a perfect payment history to making no mortgage payments at all. Most financially distressed people try to keep up with their mortgage payments at the expense of other bill payments.

– People who have high-scoring credit ratings are more likely to default strategically than people with low a credit rating.

It has been suggested that people who make the choice of strategic default are doing so because they consider their home an investment, pure and simple, and when the investment is no longer earning money, it is time to let it go. These people often keep up with payments on all their credit cards and lines of credit, while letting one large piece of their financial picture fall away – their mortgage.

Morally, exercising a strategic default could be considered a questionable practice, especially when people doing this are perfectly able to maintain the mortgage payment. But the roads to financial gain are often littered with untruths spoken or acted on to get ahead.

In a new paper entitled ‘Moral and Social Restraints to Strategic Default on Mortgages', written by financial experts Luigi Guiso, Paola Sapienza and Luigi Zingales with the Financial Trust Index, survey data showed that 26 percent of existing defaults are strategic. This would not occur if the equity shortfall was less than 10 percent, but happens regularly when home values fall by more than 15 percent.

This crisis has caused people in the financial industry to re-examine their bank risk models, and be more cautious when allowing homeowners to take out a home equity line of credit (HELOC).

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