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. NM says:

    How hard is it to find a place to rent? How expensive is it? You don’t have to own a place, you know. You could just save the money. Cash in hand those days is worth more than real estate and debt.
    And forget what you call the “ethical side” — your banker would throw you and your family under a bus if he could make a buck off it and get away with it.

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  2. Gary says:

    The credit repair guy offers interesting advice, which blurs the distinctions between the different options a bit.

    Clearly, the optimal situation for Mike, is to default on the loan, and walk away substantially richer (or, less indebted). While you maye be forced out of the housing market for a couple years, over those years, saving $1,000 a month would leave you with somewhere north of $24,000 in the bank (assuming an interest bearing account), and no liabilities on the books. The math narrows considerably if you currently have credit card debt outstanding, since the default could hurt your interest rates. The default will also impact your car loan rates, and possibly your car insurance rates, which is worth considering. Your credit can even impact your eligibility for a job, which is worth considering, depending on your job security.

    Is all of that worth $164,000 and 2 years out of the housing market? That’s much more personal, and in some ways is contingent on your income. For someone making $500,000 a year, I’d think not, especially if they work in an industry where their credit could play a role in their employment. For someone who makes $50,000 a year, its a no-brainer. Anywhere in between, and its all in the details.

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  3. jonathan feldman says:

    Mike,

    If you bought your house to live in, price and investment should be irrelevant for you. That said, I would follow Carl Bunchs advise and get out through bankrupcy, patiularly if you pay off credit cards and bills as soon as you get them.

    To Freakonomics,

    If the choice of people paying off mortgages is walk away and save money or gut it out, why did we not experience housing criseis during any previous economic downdturns since the great depression? Becuase housing prices were severly inflated for the past few years? Before the 1989 recession, housing prices went up more and faster than they did during the new century, yet the housing crisis affected only the lenders.

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  4. Mitch says:

    Contrary to popular belief, loans aren’t as “no recourse” as is commonly believed. If you willingly default on a loan which you have the capacity to pay, the bank can still come after your assets.

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  5. Jeff says:

    It’s not $140K AND $1K/mo. It’s $140K (OR $1K/mo). If you walk away, you don’t get that $140K back. If you stay, you get it back in equity eventually.

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  6. julian says:

    I know you said you didn’t want to focus on the ethical side, but I don’t see what’s wrong with walking away, from that perspective. You have a contract which specifies what happens if you break the contract, so in effect that’s just another option within the contract. This is not a human being that you made a personal pledge to, nor is anyone going to lose their job just because you (individually) walk away. If you don’t deceive anyone, or create a new [false] identity, and you take your hit on the credit score, then you’re playing within the rules of the game.

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  7. Robert D says:

    I don’t get it. You bought the house as a place to start your family. What has changed in that regard? You bought it live in and can still afford the payments — what’s the problem?

    Your car is worth less than you owe on it the minute you drive it off the lot. The difference? Aside from being a huge difference in money, is that with the car you actually believe you bought your car to use and not an investment. With the house, you’re only paying lip service to its utility, when in fact you got caught up in the whole real-estate-as-investment mentality.

    You could get into the morality of paying your debts, but I don’t think it should it even come to that discussion yet. Be honest about why you bought the house first, then figure out what to do next. If you truly bought it to live in, then be happy you have a house. (That doesn’t mean you can’t try to work something out with the bank, of course.)

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  8. David S says:

    There is nothing unethical about handing in your keys and walking away. It is a perfectly legal option available to you in your mortgage contract.

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