What is a Strategic Default?

Posted on July 10, 2012 | by Denny Oh

According to Wikipedia,  “a strategic default is the decision by a borrower to stop making payments (i.e., to default) on a debt despite having the financial ability to make the payments.”  That’s pretty clear right?  You’re upside down(owe more than it’s worth) on your home and you decide it’s better to short sell the home, rather than continue owning a depreciated asset.  In San Diego, where it’s not uncommon to find properties that are 30-50% below peak values, short sales and strategic defaults are as plentiful as its palm trees and sunny days.

Here’s an example of a strategic default:

A person, Joe, buys a home for $700K in 2005.  The home owners financial situation hasn’t changed much in five years, but now a similar home sells right next door for $490K.  Joe can still afford his mortgage payments (just as he has been for the last five years), but now he’s paying towards a home that’s worth 30% less!  Does it make sense for Joe to keep paying his mortgage?  How long will it take for his home to be worth $700K again?  How much money will he have spent to get back to where he started?  After some simple math, Joe realizes that it doesn’t make sense and short sells his home.

Since it was a primary residence, he doesn’t have to pay taxes on the forgiven debt, nor can the bank come after him for more money once he’s closed escrow.  He now goes and rents a place for half of what he was paying and saves money for a few years to buy a new home.

That’s unethical…and it’s the easy way out!  Is it?  When you get a loan, the bank agrees to lend you money in exchange for a number of predetermined payments.  If you default and try a short sale(regardless of why you do it), the bank has the option to cooperate, or not and foreclose on you.  Whether you decide if a short sale is right for you or not, is up to you.  Whether you continue to own(and make payments on) something that’s 30% upside down will likely take several years to gain its value back, is also up to you.

If you decide that a short sale may be right for you, or would like to discuss your options, please feel free to call/email me.  I won’t harass you to list with me and I’ll give you my honest opinion.  Oh and I forgot to mention that short sales don’t cost the seller anything – well at least 99% of the time(I just made up that statistic, but honestly, sellers almost never have to pay anything to do a short sale).  Let me know if you want to talk.

Denny Oh 858-243-2092 [email protected]

*Please verify with a CPA and/or attorney before you begin a short sale as the rules/laws may very depending on where you live, where the property is, or as they may have changed.  If you need a referral, please let me know.

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2 Comments

  1. Jim says:

    Great post. I did a short sale in 2008, before the term was even used. I’m proud of my financial decision but due to its fiscal responsibility and ethics. The agreement with the bank contemplates non payment and provides the bank an asset in that event. Should the asset become worth less than the loan, an error was made by both the bank and the buyer, and to suggest that only the buyer shoulder that burden, is just silly.

    Look around at all of the banks letting their own property go into foreclosure due and you can see that many hold them to business standards while individuals are held to some other “ethical” standard.

    These are no credit cards or HOA payments where you agree to pay and, if you do not, the creditor will get nothing. These are secured loans where everyone takes a risk and sometimes everyone gets burned. The owner in his credit and down payment and the bank in the underwater portion.

  2. Denny Oh says:

    Hi Jim,

    Thanks for the feedback. This is certainly a heated topic and opinions are not scarse. I think short sales are more “acceptable” in todays market, but clearly not everyone thinks its morally, or ethically right. I guess my point is that everyone needs to decide what’s best for them and proceed accordingly.

    I also think it’s easy for people to judge if they haven’t been in a similar situation. It sounds like everything worked out for you and hopefully you’re in a much better situation now!