Our Daily Bleg: A Real-Estate Dilemma

Mike, a 30-year-old engineer, writes in with a real-estate dilemma in which he’s considering a tricky tradeoff: is it worth sabotaging his own credit rating in order to walk away from a house that’s worth far less than his mortgage?

I am hoping he can glean some good advice from those of you who may work in related fields. (Considering your fervent response to a recent post about homeowner bailouts, he probably won’t be disappointed.) Here are the details:

My question is about my current housing situation and when (if ever) it makes good economic sense to walk away from an underwater home. My new wife and I bought our home in Temecula, Calif., as a place for us to start a family, not as a get-rich-quick investment or because we expected the value to go up in the near term. However, we never expected the value to crash the way it has.

We bought the house in early 2007 for $445,000 and put $50,000 down (the lender encouraged us to put zero down, but even though $50,000 was a huge amount of money for us, we felt more comfortable with some equity in the home and a lower monthly payment). So our mortgages totaled $395,000. Now that the market has crashed in our area, our house is worth about $250,000.

Our home value is now about $140,000 less than we owe on our mortgage and our $50,000 down payment is essentially gone. Although our monthly mortgage payments are high, we can still afford to make them, but should we? If we walk away and buy another house with my parents cosigning on the loan (or even just rented a place), we could save almost $1,000 a month in payments and maybe even have positive equity in the next few years. If we stay in our home, we’ll be stuck for many years, and if the market ever does get back to what we paid, the best option we’ll have will be to break even with a sale and then buy another house with an inflated value.

I’m certainly concerned about the ethical side of it, and know that walking away is not “the right thing to do.” But my question is from a purely economic perspective and I’d be saving a significant amount of money by lowering my monthly payments and erasing $140,000 in debt.

Since California is a “non-recourse” state, all the loan company could do is take the house. And the Mortgage Forgiveness Debt Relief Act of 2007 states that through 2012 the I.R.S. will not count forgiven debt as taxable income. So the only financial downside appears to be a destroyed credit rating. Am I missing anything?

So the big question is: how much is my credit rating worth? Is it worth more than $140,000 plus $1,000 per month?

Now imagine a few hundred thousand Mikes, or maybe a few million, and you can see why real estate will remain a mess in many parts of the country for years to come.

How flexible will his bank be in a renegotiation? There is the chance, of course, that his own home will regain its value in time, but that time frame is a big question mark. Some of you may want Mike to double down and buy another house while values are low, but I doubt that is an appealing option.

Please give Mike the best insights you can.

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  1. TonyW says:

    If personal ethics matter… and he can make the payments… Mike is asking permission to screw his counter party simple because he has the opportunity.

    If he were a business, such a sentiment would be short sighted at best, and illegal and evil at worst.

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  2. Brenda says:

    Mike’s comments about why he purchased the house (“a place for us to start a family, not as a get-rich-quick investment or because we expected the value to go up in the near term”) holds the answer in my opinion.

    That house STILL meets those criteria. Mike said he is able to make the payments, so it is not a matter of mortgage payment vs. other bills.

    I don’t mean to make light of the gut wrenching fact that the home’s value is less than you owe, but that “value” is only a number that turns into reality at the time one tries to sell.

    Since Mike can make the payments, and the house is meeting its original “reason for being” … to provide shelter and a place to start a family, I see no reason to inflict years worth of damage to your credit score. Remember that your credit rating affects what you pay for car insurance, interest rates charged you, even the ability or not to get a job (credit checks are routine parts of job applications these days).

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  3. Jamie says:

    @ Carl Bunch — Why would he want to file bankruptcy? That doesn’t make any sense at all. A bankruptcy is only useful if you need to discharge unsecured debt that creditors are pursuing. His options here are: (1) keep paying on the house, keep a good credit score, and hope that the home value will eventually go up to a more reasonable value; or (2) work something out with the bank.

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  4. Dober says:

    I have to agree with Jonathan. I’m a banker (on the commercial side though), and I would suggest that you talk to the bank first and see if they can re-negotiate the mortgage. You won’t get the full amount reduced, but you would still save a lot of money, and have the house for when the market eventually rebounds.

    If that’s not possible, then, I would go with Carl’s advice. You won’t be able to buy a house for two years, but that doesn’t mean your parents couldn’t buy it for you and sell it to you two years later when you can qualify for a mortgage again.

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  5. Kit says:

    Though phrased very politely and realistically, Mike’s letter is exactly what’s wrong with the economy and the people that make it up (don’t even get me started on the recommendations of comment #1, that’s just straight up gaming the system). You have to be accountable for your actions, otherwise trust (and the rest of the economy) breaks down.

    Mike, did you sign a contract saying that you’ll pay X amount of dollars for the next Y years? Can you still afford to make those payments and feed/clothe your family? It seems like the answer to both of those questions is yes. So guess what, you need to hold up your end of the bargain and keep on paying that mortgage.

    When you purchase anything whatsoever, you are taking an implicit risk that that thing may not be worth as much in the future as it is right now. You’re basically saying that since you ‘lost’ in this transaction, you shouldn’t have to pay the consequences. If the home went up in value, would the lender have a right to raise your monthly payments because the home is now worth more?

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  6. Jeffrey Trapnell says:

    Perhaps you should ask, what is the ethical thing to do before the economical thing to do. When you bought the house, you agreed to the terms of the loan and in return to you received ownership of the house. How about this question, what is the value of your signature and your word you gave to the bank? Is it only worth $140,000 plus a $1000 per month.

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  7. Chris says:

    The question — what is my good credit worth in economic terms? — is an interesting one but not one that I am qualified to help answer. What I can add is that the cost differential between walking away and staying put may not be $140k plus the present value of $1000 per month. A discussion with your bank, especially if you enlist the help of a real estate attorney, may enable a favorable adjustment to the loan terms or even the principal amount. Many banks in Southern California have been quite willing to play ball when it means that they can avoid taking on another unsellable foreclosed property.

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  8. rdhd says:

    Mike, like many other people, apparently thinks economists only deal with money. If he wants a benefit-cost analysis of paying versus defaulting, he should assign a value to “doing the right thing” and a cost to him giving yet another mortgage lender yet more bad debt and causing his neighbors’ property values to drop (or any other negative effects that will be imposed on others).

    -rdhd

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