When to Walk Away From Your Mortgage

If you have a mortgage for an amount greater than the value of your property, what do you do? If you’re the owner of the largest residential property in Manhattan, you might decide to walk away, leaving the mess to your creditors while you go on about your business.

In fact, that's precisely what happened when Tishman Speyer, the American company that invests in real estate, abandoned the 11,000-unit Stuyvesant Town and Peter Cooper Village in Manhattan in 2010. It was one of the largest defaults in history—and the company still managed to remain in business. Tishman Speyer was merely following in the path of many commercial real estate enterprises that had gone before it.

However, if you’re a residential mortgage holder, walking away from a mortgage will likely look different than this (it is unlikely to be as clean and easy). Still, it may surprise you to hear this advice: Mathematically speaking, walking away can sometimes be the most prudent choice.

When Walking Away Makes Sense

Prior to the national housing bubble of the late 2000s, real estate prices could generally be counted on to increase over time. While a few geographical regions would occasionally see declining values, on a national basis, homes gained in value over time. Up until this point, this had been the long-term trend in the U.S.

However, in 2008 and 2009, property values plunged (at times, posting double-digit declines in value). As 2009 came to a close and the year 2010 opened, 23.1% of all mortgages nationwide were underwater—the amount owed on the mortgages was greater than the value of the homes. At this point, what was previously unthinkable to some actually occurred: Borrowers who could still afford to make their mortgage payments decided not to do so.

If you can rent a similar-type house for less than the cost of the mortgage, some experts suggest that walking away from a house is a sound financial move. In a scenario where you are underwater on your mortgage and facing rising interest rates (due to an adjustable-rate mortgages), the incentive to walk away may be even more appealing. (When a housing crisis strikes, the big winners are often renters.)

Calculating the Cost of Walking Away From a Mortgage

The calculation for comparing the cost of rent to the cost of a mortgage is a simple calculation. One tool to estimate your monthly mortgage payments is a mortgage calculator. 

Determining the amount of time it will take your home to recover its lost value is a slightly more complex effort. Using a 5% yearly increase in value will provide a ballpark figure based on national averages. A little research can help you make adjustments for regional and local markets. Consider an example:

• Original price: $200,000
• Today’s value: $150,000
• Loss in value: 25%

If real estate values climb at an average of 5% per year, it will take six years for this home to reach its sales price. This gets the owner to a break-even level—but there is no profit to show (and the owner has paid interest on the loan every year). If prices fall another 10%, recovery will take even longer. (Obviously, home price appreciation is not assured.)

• Original price: $200,000
• Value after 25% decline: $150,000
• Value after another 10% decline: $135,000

The recovery time is now more than eight years.

Methods for Getting out of a Mortgage

Three of the most common methods of walking away from a mortgage are a short sale, a voluntary foreclosure, and an involuntary foreclosure. A short sale occurs when the borrower sells a property for less than the amount due on the mortgage. The buyer of the property is a third party (not the bank), and all proceeds from the sale go to the lender. The lender either forgives the difference or gets a judgment against the borrower. Then, the borrower is required to complete the payment of all—or part of—the difference between the sale price and the original value of the mortgage.

In a voluntary foreclosure, the homeowner turns the property over to the lender willingly. To arrange a voluntary foreclosure, talk to your bank, and make arrangements to deliver the keys to the property. While this process will have a negative impact on a homeowner’s credit rating, additional payments on the mortgage are no longer required.

Involuntary foreclosure is initiated by the lender for non-payment. The lender uses the legal system to take possession of the property. While the homeowner is often allowed to live in the property for months (free of charge) while the foreclosure process takes place, the lender will be making an active effort to collect on the debt and, in the end, the homeowner will be evicted.

The Double Standard

Companies routinely cut their staffing levels and restructure their debt. This can hurt (and sometimes destroy) the suppliers they don’t pay. However, these are considered "good" business moves; stock prices for these companies usually rise in the aftermath.

However, when an individual homeowner attempts to make the same decision, the legal system is set up to protect the lender’s profits. While only a minority of banks will agree to a short sale for a homeowner, all of them are willing to foreclose.

A level playing field for consumers and businesses would mean that homeowners should feel no remorse about walking away from a loan than businesses that default or have properties foreclosed. As the field is not level, borrowers who walk away need to be willing to accept the consequences, which can include damaged credit, harassment by collection agencies, and difficulty obtaining credit for years.

The Bottom Line

After completing your research, if walking away is your best option, be prepared. To make sure you have a place to live, buy a new, smaller home—or rent an apartment—before you walk away from your current home. Purchase a car and any other big-ticket items that require financing before your credit score is downgraded, and set aside some cash to help smooth the transition.