Strategic Defaults Hurt Other Homeowners

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Everyone knows that falling home prices and high unemployment are bad news for the housing market and economy. Economists worry that people who can’t afford their mortgage payments will default, leading to foreclosures, a glut of homes from sale, driving prices down further. You get the picture — a vicious cycle.

Well, now add something else to this gloomy scenario — strategic defaults. This refers to people who can afford their mortgage payments but simply choose not to make them. The most likely reason is they see no reason to continue payments on a home that is worth less than they owe.

Experts have been worrying about this for some time, but now economists at Moody’s Economy.com warn that strategic defaults could "derail housing recovery."

"Such so-called strategic defaults, once rare, are now common enough to jeopardize the already-weak housing and mortgage markets," wrote Celia Chen and Cristian deRitis. "If the trend continues, strategic defaults could both accelerate the pace of home foreclosures and also make it harder for new borrowers to obtain mortgages. Both factors would in turn worsen the decline in house prices."

Citing a variety of studies, Chen and deRitis estimate that 20%-25% of recent mortgage defaults are strategic.

"Borrowers watching their largest asset rapidly sink in value may easily conclude that they were misled by lenders and are thus justified in walking away," they write.

According to Economy.com, about 15.5 million homeowners are underwater, owing more than their homes are worth, up from less than 3 million in 2006. That means one in five homes is underwater. About 9 million borrowers owe at least 25% more than their homes are worth.

Certain parts of the country, generally those that had the biggest home-price bubbles a few years ago, are even worse off. More than 60% of homeowners in Nevada are underwater, for example.

"A further rapid rise in the number of strategic defaults could leave banks and other lenders holding many more distressed properties," Chen and deRitis say. "As these are added to the already-glutted market, house prices will fall further, exacerbating the problem that led to strategic defaults in the first place."

To make things worse, lenders who are facing losses may respond by tightening standards on new loans and raising borrowing costs. Making it harder for home shoppers to get loans will reduce demand, further undermining home prices. Economy.com expects home prices to fall throughout 2010.

If all this is true, home shoppers should proceed with caution, as there’s a chance the home you buy this spring could be worth less by winter. Beware of neighborhoods that have large numbers of foreclosures. Zillow.com can display foreclosures in the neighborhood surrounding any address.

Homeowners thinking of walking away from their mortgages should remember that this can be very damaging to one’s ability to borrow in the future — not just for homes but for cars, college and credit cards as well. In fact, many employers check job applicants’ credit histories. Walking away from your mortgage could cost you the new job you need to repair your finances.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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