Choosing not to pay has consequences beyond damaged credit scores!
CHICAGO (MarketWatch) -- "Strategic defaults" are on the rise as more borrowers who are underwater on their home loans decide it's not worth it to stay current on their payments each month. That trend could have repercussions for the housing market, and for borrowers, in the future.
Strategic defaults are when borrowers who owe more on their homes than they're currently worth choose to stop paying their mortgage but continue to meet other financial obligations, according to a definition by Morgan Stanley in a research report on the topic.
The Morgan Stanley report estimates that 12% of mortgage defaults in February were strategic. Other reports estimate an even higher proportion of this type of loan default.
Growing social acceptance of this behavior could have ramifications not only for personal credit histories and the health of neighborhoods, but also for the future of mortgage lending, according to those studying the issue.
For one, there's a contagion effect: As more people watch their friends or neighbors choose to default, the more it becomes a viable option for homeowners who may otherwise wait years just to return to a positive equity position in their properties, said Sam Khater, senior economist for CoreLogic, a provider of consumer, financial and property information. The volume of foreclosures on the market today is also chipping away at the stigma that used to come with defaulting on a home loan.
"If you know someone who has defaulted strategically, you're more likely to declare you're willing to do it," said Luigi Zingales, professor of entrepreneurship and finance at the University of Chicago's Booth School of Business.
In areas where home prices are severely depressed, social acceptance of this decision could lead to pockets "where strategic default becomes the norm, versus the exception," Zingales said.
But look even farther in the future, and the repercussions of substantial strategic defaults could have a larger-scale effect.
"If it really does become a legitimate problem, the implications are pretty dramatic for anyone that wants to buy a home in the future," said Rick Sharga, senior vice president of RealtyTrac, an online marketplace of foreclosure properties. "The lenders would have to build this into their risk models with either larger down payments or higher interest rates."
Some owners 'mimic investors' Many agree the ranks of people taking this route are growing, but putting a number on the trend isn't as easy. To measure the number of people who are strategically defaulting on their mortgage obligations, you have to assess borrower intent.
"Take all the numbers with a grain of salt, because it's one of those topics which is really difficult to get a firm grasp on," Sharga said. "The projections are based on limited sample sizes, and [people are] doing projections that have a lot of implications on societal behavior and political policy."
Researchers believe that being underwater on a loan is a prerequisite to strategic default, and the more underwater you are, the likelier you are to consider defaulting -- even if you can afford to keep making payments.
"In our data, what we've noticed is at about 25% negative equity, the behavior of owners begins to mimic that of investors -- they're more ruthless and rational, they're looking at it from a cash-flow perspective," Khater said. "The default rate rises as the negative equity gets deeper and deeper."