I hope everybody liked the quiz last week.
One of the questions involved reducing your real estate exposure by buying a house with a big mortgage. I wrote it intending that the right answer be that the size of the mortgage had nothing to do with your exposure to real estate, but as I entered it into the quiz template I realized that there was another argument to be made. And sure enough, somebody suggested in the comments that mortgaging a house up to its full value does reduce your exposure because you have the option of walking away from an underwater house, i.e. one that becomes worth less than the balance on the mortgage.
The idea that you can just send the keys to an upside down house to the mortgage holder (“jingle mail” or more properly “ruthless default”) and be done with it seems to have gained some popularity of late. Apparently, some people are beginning to believe that this is something special about houses. New cars that were bought on credit are usually worth less than what is owed on them at the start. Does anybody think they can reconsider the purchase after a few months and just hand it back to the dealer, no questions asked? Are houses different? Can you just mail in the keys?
This is one of those unsatisfying questions where the answer is kinda yes and kinda no.
The argument in favor of no is that there is only rarely a contractual right to hand over the property to the mortgage holder and walk away unscathed. Houses don’t borrow money, people do. When you sign a mortgage, you owe the money and the fact that the security for the loan, your house, may have sunk in value does not mean that you owe any less.
It is true that in 19 states, notably including California, mortgages are by law non-recourse, meaning that if a lender forecloses on a property they cannot come after the debtor for more money even if what they get for the property doesn’t cover the balance on the loan. However, in many of those states, again including California, the lender need not foreclose. They can just sue you for the money if they think you are good for it.
On the other hand, the argument in favor of homeowners being able to walk away from an underwater house is supported by a some practical realities. Even in the best of times lenders rarely went after homeowners for the difference between what was owed and what was recouped in foreclosure, for the obvious reason that those homeowners were usually broke. That’s how they wound up in foreclosure.
And now is not the best of times. With so many homeowners in trouble, mortgage servicers are even less likely to pick out the few who have other assets that could be tapped to make up a deficiency. Short sales, a sort of pseudo-foreclosure in which the lender agrees to settle for the proceeds from the homeowner’s sale of the property, once an exotic maneuver, are now commonplace.
Which is not to say that the ability to walk away from an upside down mortgage can be taken for granted or considered anything like a normal business practice. For one thing, a short sale is a blot on your credit rating, not to mention a complicated ordeal of negotiation you are unlikely to enjoy. And things change. It could be that in a few years, when you want to walk away, you will find that you are dealing with a clever bank that isn’t so open-minded.
Walking away from an underwater house is possible, but it is a desperate act for desperate times, not a fallback option you have if things go against you.