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 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?