Articles

When To Walk Away From a Mortgage

In Statistical Analysis, Statistics on January 8, 2010 by David Tagged: , , , , ,

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Summary: The financial repercussions for a foreclosure on a high end mortgage is estimated to be $21,000. When your residential property is worth $21,000 less than your mortgage, it might be a rational choice to walk away from the mortgage.

Background: With the recent economic downturn, there are a significant number of people with mortgages that are worth more than their house. Particularly in the western states, there are a number of overvalued mortgages due to local housing bubbles and the sliding prices and volume of housing sales. Because they bought their house when there was a housing bubble and now the house is worth much less than what it is being paid to the mortgage company, they are ‘underwater’. 65% of residential property mortgages in Nevada are underwater.

My question is now; at what point is it rational to walk away? With the overreaching and speculative lending of large banks, there are a significant number of mortgages to individuals without the ability to afford them. At that point, with an overwhelming mortgage, would it be more financially viable to try and start over or to continue walking the harrowing tightrope?

My question is not a question of morality or ethics (this question is approached in this New York Times article), but about the practical implications if one chooses to walk away from a mortgage. In other words, how far underwater does a property need to get for it to be a rational choice to walk away? Obviously, if your house suddenly becomes relatively worthless, it does not make sense to keep paying your mortgage payments, but when should the homeowner decide it is worth the lowered credit score to be foreclosed on the mortgage?

Put in another way, what is the value of the credit score? The value of credit score, or FICO score, depends on the amount of debt one wants to hold after default (as it determines the amount of interest one would need to pay) and whether you would jump from one tranche or subdivision to the next. (If a bank offers certain loan conditions to individuals with scores of 650 – 720, a score drop from 716 to 655 does not make much of a difference, but a drop from 716 to 649 would make a world of difference). I am interested in getting a ballpark estimate of the cost of having a low credit score.

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Approach:

1. Estimate how much the FICO/credit score drops as a result of the foreclosure.

2. Calculate the present value of the difference in interest payments. The assumption is that once you walk away from your current mortgage, you will obtain another house at a lower price (although the mortgage would be on worse terms).
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Assumptions:

1. The financial repercussions will be limited to approximately 7 years. Line items on your credit score report remain on your record for only 7 years, and cannot be considered after that timeframe. There is also a public record, but can also be removed after 7 years if requested.  So the difference should be the present value of the difference in interest for 7 years. After that time, one can refinance or approach different financial solutions.

2. Some websites overestimate the value of the FICO score (credit score) because they assume the different for the lifetime of a 30 year loan. Because it is very reasonable, readily available, and in your best interests, we will assume you will refinance after your credit score improves in 10 years. This website estimates a 25 point different to be worth $31,002, which is the difference between paying $1,189/month vs. $1,275/month for 30 years.   But this also gives us an upper ballpark, because the previous example (1) chooses a credit drop that directly drops the borrower from one tranche to the next , (2) chooses a 200,000 30yr fixed mortgage rate, a relatively large loan for the average American consumer, and finally (3) does not discount for the time-value of money. Taking into account the ability to refinance after 7 years and the time-value of money (with a discount rate of 0.50), the value of monthly payments of $86 over seven years is $5,886.96.  (This is the upper ballpark for a 25 point drop in credit score).

3. There are limited other financial repercussions. Articles also mention differences in cost in respect to insurance, but I hypothesize that this would be a minimal impact compared to difference in mortgage payments. As this is simply a rough ballpark, I will simply add an extra 5% to signify any additional, unforeseen credit repercussions.

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Calculations:

  1. The impact on FICO score will be estimated to be 240.

The foreclosure’s actual point impact on an individual’s credit report is estimated to be from 125 to 175 points. The bigger impact is from the late payments on other bills which quickly mount up. The net effect is generally considered to be about a 240 point decline counting his late mortgage payments. Ironically, the lower your credit report to start, the less the impact of additional late payments, and if you get into the 400’s, it’s really hard to get much lower without almost trying to hurt yourself. Many of the items on any credit report can be removed over time. It requires persistence and it’s estimated that 30% of all items on credit reports are incorrect and can be removed just by an inquiry or showing a paid invoice. Also the credit score reduction for the foreclosure is reduced as time goes on, until it settles at a minimal deduction (50 to 75 points) after a few years.

From: http://www.articlesbase.com/real-estate-articles/how-much-does-foreclosure-affect-your-credit-score-456243.html

We assume that since you are willfully walking away from your underwater mortgage, you can still afford your other payments, and you will limit other impacts to your credit score. We will estimate the impact on your credit score overall will be 150 points (the midpoint between 125 and 175). This would put your new FICO score at 573. A good number, as the lowest score to qualify for a mortgage is usually around 560, but then again the impact of the foreclosure on your FICO score would be less if you start initially with a bad credit score.

2. We estimate the difference in payments between a FICO score of 723 and 573.

From Bankrate.com :

FICO score Amount of loan Interest rate Mo. payment
720-850 $200,000 5.922 $1,189
675-699 $200,000 6.584 $1,275
620-674 $200,000 7.734 $1,431
560-619 $200,000 8.531 $1,542

What is the present value of the difference in monthly payments of $1,542 and $1,189 for 7 years? This is a monthly difference of $353. Using the Present Value calculator, the present value is $19.996.90 when there is a discount rate of 0.500.

Note: This is a relatively low rate, assuming there is little/no inflation, where a more reasonable discount rate of 2.000 would have the present value be $14,305.51. So my ballpark MIN/ESTIMATE/MAX is $14,000/$20,000/$30,000 when the discount rate (similar to the interest/inflation rate) is at 2.00/1.00/0.00 respectively.

3.  Add an extra 5% for a conservative estimate and any other unforeseen financial impacts of a reduced credit score. My point estimate would be that this foreclosure would cost you an estimated $21,000. This is under the assumptions of $200,000 mortgage on your new house (this would be significantly less if you choose to rent or not borrow money during the seven years), a discount rate of 1.000, and an initial score of approximately 723.

Conclusion: Twenty thousand dollars is not a small sum of money. In most situations, it is not rational to simply walk away from a mortgage. But in select situations, where there is a significant downturn in property values, it can be better for your financial future to face foreclosure.

From the same NYTimes article:

And given that nearly a quarter of mortgages are underwater, and that 10 percent of mortgages are delinquent, White, of the University of Arizona, is surprised that more people haven’t walked. He thinks the desire to avoid shame is a factor, as are overblown fears of harm to credit ratings. Probably, homeowners also labor under a delusion that their homes will quickly return to value. White has argued that the government should stop perpetuating default “scare stories” and, indeed, should encourage borrowers to default when it’s in their economic interest. This would correct a prevailing imbalance: homeowners operate under a “powerful moral constraint” while lenders are busily trying to maximize profits. More important, it might get the system unstuck. If lenders feared an avalanche of strategic defaults, they would have an incentive to renegotiate loan terms. In theory, this could produce a wave of loan modifications — the very goal the Treasury has been pursuing to end the crisis.

Notice: The article does not constitute financial advice and comes with no warranty, guarantee, or liability. These are merely back-of-the-envelope calculations meant to highlight all possible options. Please consult a licensed professional before making significant financial decisions.

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