Should You Walk Away When Your House is Underwater?

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By the end of 2012, it has been estimated that over half of Americans will be “underwater” on their house.  In other words, they will owe more to their mortgage company than the house is worth.  Currently, it is estimated that one out of ten homeowners are underwater.  This is making it very difficult for homeowners to sell their houses, since the owner of an underwater house will have to bring a check to the closing table, often for thousands of dollars.

As a result, many homeowners are choosing to “walk away” from their mortgage obligation; otherwise known as voluntary foreclosure.  Banks in housing markets that have been hit hard by the latest housing bust (typically in Florida, California, Arizona, and Nevada) are receiving “jingle mail” or envelopes with house keys mailed in by the owners.  Deciding whether or not to walk away is a very difficult decision, and it can be influenced by a number of factors.

The first thing to realize is that walking away from a house (and the accompanying mortgage note) is considered to be a foreclosure.  Unlike car loans where credit bureaus look at a voluntary repossession in a slightly more favorable way than an involuntary repossession, there is no such distinction when it comes to home foreclosures.  A foreclosure will stay on your credit report for seven years and it will cause your credit score to decrease by about 150-200 points.  The decrease in your credit score will cause you difficulties if you try to finance any other major purchases or apply for a new credit card.  In addition, your credit report is accessible to your insurance company and your current and future employers.  Typically, people with jobs in the government, military, or finance sectors should avoid foreclosure for as long as possible due to the repercussions of this “hit” on their credit score.

The most serious consequence of a voluntary foreclosure is that you will be unable to purchase another home until the foreclosure “falls off” your credit report.  During the period of relaxed lending practices in the early 2000s, many people with foreclosures as recent as two years old were able to obtain new mortgages.  Unfortunately, many people do not realize that these guidelines are no longer in effect, meaning that it will be very hard to obtain a new mortgage until seven years have passed.  For many people considering this step, however, it is simply impossible to maintain the monthly payments on their current home, and circumstances will prevent them from saving a 20% down payment for their next home for several years.

Many other people, though, are considering this step simply because they do not want to continue to pay towards a depreciating asset.  Todd Baker (name changed to protect privacy), who bought a home in the Panhandle area of Florida in 2006 for $350,000 knows about this.  “When I bought my home, I thought I was making a good investment.  I thought that buying a home and building equity was smarter than paying rent every month.”  Today, however, he believes his house is worth about $220,000.  “In just three years I’ve lost about $130,000.  It will take me at least ten years to pay that back to the bank.  I might as well just give the keys back and rent for seven years before buying again.”  Many people in Baker’s position feel the same way.  In his case, he looked at the amount he was spending on his monthly mortgage payment and the amount he would spend on a rent payment for a similar house.  He would have saved nearly $300 a month by renting, not to mention the costs of maintenance.  Eventually, though, other factors convinced him to stay in his house.  “I looked at the effect that foreclosure would have on my credit score, and in today’s lending environment, I knew the interest rates on my credit cards would go up.  That would have eaten up almost $100 of what I would have saved each month.”  Baker also looked at the costs of moving, the amount of money he would need to for deposits, and the availability of rentals in his area.  Eventually, he decided to stay put.  “I can keep making the payments, my wife loves the neighborhood and the schools, and when the market starts to go back up, I’ll have some equity in the house.”

In general, it only makes sense to walk away from an underwater home if you are having trouble making the payments.  If you intend to stay in the house for a long period of time and can make your payments, going into foreclosure will do more harm than good.