A strategic mortgage default happens when mortgagees — that is, people who have taken out mortgages to buy houses or other real estate — decide to stop making their mortgage payments, effectively transferring the property back to the lender. This kind of default is most common when a home’s appraised value has fallen far below the outstanding money owed. Mortgagees who determine that it is not in their best interest to continue paying money into a mortgage that is considered “upside down” simply abandon it, effecting a strategic mortgage default.
There are different definitions of what an upside-down mortgage is from a financial standpoint. Practically speaking, though, any time the debt owed on a property is greater than its assessed value, the property can properly said to be upside down, or "under water." Strategically thinking through the financial ramifications of paying money into a property under these conditions leads many investors to simply walk away, cease payments and vacate the premises. Many people believe that the money that they would spend to own their devalued home would be better spent investing in a new, lower-priced property.
Mortgages are assessed in large part based on a home’s appraised value at the time of original purchase. When the market is good and homes are expensive, mortgage payments usually are high. It is rare for mortgage rates to fluctuate with changing housing markets or shifts in economic stability, however. If a home’s value plummets, the mortgage payment usually remains unaffected.
The average mortgage life in the United states is 30 years, with comparable numbers in Canada, Australia and much of Europe. In stable markets, homes generally appreciate, which means that a mortgage on the original value often works out to be a fairly good deal for people who can make the payments but simply do not have the money to pay the full purchase price at once. A lot can happen in 30 years, though. Facing decades or more of payments on a mortgage that is upside down is what prompts most strategic mortgage default decisions.
A strategic mortgage default is different from a foreclosure. Foreclosures happen when mortgagees simply cannot pay their mortgages anymore, usually as a result of job loss or other financial difficulty. People who are contemplating strategic mortgage default usually can make the payments; they simply choose not to as a strategic investing decision.
A strategic mortgage default does succeed in getting investors out from under negative equity situations, but it usually comes with significant consequences. Voluntary defaults usually are not recommended from a strategic management perspective, because they can significantly damage the investors’ credit rating. Credit scores are based on a composite of debts outstanding, payment histories and general creditworthiness. Choosing to back out of a mortgage — which is a significant contractual agreement — usually has dire consequences for a credit score, to the extent that investors might have a difficult time securing new loans or even renting properties far into the future.
Many investors who are contemplating a strategic mortgage default will seek a short sale first. A short sale happens when the house is sold on the free market, with the proceeds being applied to the mortgage debt. The sale amount is always less than amount owed, which is why the sale is referred to as “short." These arrangements sometimes benefit banks, because the revenues from short sales often exceed what could be earned at an auction after default. Banks do not always agree to short sales, however. Much depends on the location, the market and the investors’ general financial position.