Why Pay An Underwater Mortgage?

Closing the purchase of a new home is often stressful, but it usually is exciting, too. Not only do you get the house you want, you get the opportunity to build wealth as you pay down your mortgage and — you hope — watch the value of your investment increase.

As we all know by now, it does not always work out this way. Home values can fall as well as rise. What if, despite months or years of making mortgage payments, you find that you owe more than your house is worth? Should you keep paying, or just hand the keys to the bank and walk away?

Many homeowners who bought during the real estate boom now face this dilemma. As of September 30, 2009, nearly a quarter of residential properties with mortgages were underwater. In Nevada, one of the hardest hit states, 65 percent of homeowners with mortgages owed more than their home’s value.

Some in this situation have no choice but to give up. Their incomes have fallen along with the housing market, and they can no longer afford to make payments. So they default.

Others have a choice but still surrender their homes. Those who opt for a “strategic default” could afford to stay put but voluntarily default because it is their most financially advantageous option.

In a recent New York Times column, Richard H. Thaler, a professor of economics and behavioral science at the University of Chicago’s Booth School of Business, questioned why more people with underwater mortgages don’t voluntarily default. He noted that most underwater borrowers “are dutifully continuing to pay their mortgages, despite substantial financial incentives for walking away from them.”

In some states, homeowners face the risk that, if they default, the bank will take not just their home, but also their other assets, to make up the difference between the home’s value and the outstanding debt. In other states, including California and Arizona, both in the top five for underwater mortgages, mortgages are nonrecourse loans, which means the lender has no claim to any of the borrower’s resources other than the home itself. If returning the house isn’t enough to repay the loan, the lender is out of luck.

In Thaler’s view, homeowners who continue to make payments on underwater mortgages when they could get off the hook are laboring in vain, trapped by overly strict morals that are irrelevant in modern society. Meanwhile the bankers, who Thaler asserts have no such compunctions, swap mortgages as quickly as Las Vegas dealers shuffle cards to maximize their own profits. (If a banker sells your loan, however, your financial obligations are unchanged. Absent a borrower’s default, a mortgage lender cannot just walk away from a completed transaction.)

But homeowners may have more sense and fewer delusions than Thaler thinks. Even if they do not risk losing other assets when they default, they do risk damaging their credit ratings and future access to loans. This could be particularly devastating to small business owners or those who hope to own small businesses someday, since owners frequently must personally guarantee small business debts. The guarantee of a “strategic defaulter” isn’t worth a whole lot.

People who stand by their mortgages also may hope that home values will rebound. For those who don’t intend to sell their homes in the near future, the current value matters less than the future value. In some markets, housing prices were so wildly inflated that homeowners should not hold their breath waiting for a full recovery, but in many cases even a modest return of value could be enough to make it worth sticking with the mortgage, especially when the emotional and social costs of moving are considered.

Still, there may be a few situations in which, when everything is considered, an individual would do better to walk away than to stay. But, even though the individual may benefit from a default, society does not. Each person who defaults chips away at lenders’ confidence that the loans they grant will be repaid. This will lead lenders to increase costs for everyone in order to cover their anticipated losses from defaults. Already, borrowers in nonrecourse states pay an estimated $800 in additional closing costs for each $100,000 they borrow because of the extra risk defaults pose to lenders in those states.

Since everyone depends on the banking system, saving a few dollars at the expense of your lender hurts not just the lender, but also future borrowers.

So is a homeowner who decides to keep making mortgage payments even when he’d be better off defaulting just making a charitable contribution to his bank? Maybe, but as they say, charity begins at home.