Owing More Than the Home is Worth? Voluntary Mortgage Default and Its Consequences

Is it ever in a homeowner’s interest to voluntarily default on a mortgage by not paying it? How about if the homeowner is “underwater” or “upside down,” which means the homeowner owes more on the mortgage than the home is worth? As with most legal questions the answer is, “it depends.” It depends on the circumstances.

First, take the situation of a homeowner who is underwater but can afford the mortgage payments. This would be someone whose monthly income more than supports the mortgage and other home-ownership costs (e.g. taxes). A homeowner in this situation should probably keep the home and keep paying.  The main reason for doing this are the profoundly negative consequences of defaulting:

  • Losing the home (foreclosure)  Possibly being sued for the balance remaining after the home is sold in foreclosure by the lender (a “deficiency judgment”, which is allowed by a majority of states)
  • Almost as great a negative impact on credit as bankruptcy

There are also positives to consider: the homeowner will have a place to live; and the home’s equity may rise in time. It’s similar to renting with the potential for economic upside (a gain in value), which may not be your first choice, but is hardly horrible.

Even if the homeowner is unable to support the mortgage, if the equity shortfall is minor $10,000 or $20,000, and the homeowner has the savings or assets to pay that shortfall at closing without becoming impoverished, he or she is probably better off selling at a slight loss. Paying several thousand dollars at closing is probably better than the credit impact and potential lawsuit resulting from default.

If the homeowner can’t afford the monthly cost of the home and can’t afford the loss, then he or she needs to consider other options. First, the homeowner should try to negotiate a short sale with the bank.  While it can be a painful and frustrating process, a short sale will wipe out the equity loss if the bank allows it. It’s well worth trying before defaulting.

Even at short sale prices, there are times when there are no buyers. If the bank doesn’t allow a short sale, or it does and there are no buyers, the homeowner may need to consider defaulting. As bad as default is, if the alternative is for the homeowner to burn through his savings and then have to default later when the money runs out, it’s better to default while there are savings or assets to fall back on. However, if the homeowner is in a state which allows deficiency judgments, he or she may want to consider filing bankruptcy as well. That way, if the bank does sue him or her, the homeowner will avoid having to pay yet more on a home he’s already lost.