Borrowers who engage in "strategic defaults" after their home's value has plummeted tend to be more savvy about credit than the population at large, with higher FICO scores, lower revolving debt balances, and lower retail credit card usage. However, most do not understand the full consequences of their actions.
According to a study by Fair Isaac Corp., developer of the FICO score, which says it's helping lenders identify borrowers who are most likely to engage in strategic defaults.
In a strategic default, "underwater" borrowers who owe more on their mortgage than their home is worth stop paying their mortgage -- not because they can't afford the monthly payments, but because they don't believe their home will regain its value anytime soon.
Home-price declines have left 11.1 million homeowners underwater, according to a study released in March by loan data aggregator CoreLogic. Studies by the University of Chicago Booth School of Business have estimated that 31 percent of mortgage defaults in March 2010 were strategic, up from 22 percent in March 2009.
Fair Isaac has also been studying the impacts of mortgage delinquencies, short sales, foreclosures and bankruptcies on credit scores.
Looking at three "representative profiles" of consumers with scores of 680, 720, and 780, FICO found that those with the best credit scores took the greatest hit on their scores when falling behind or defaulting on a mortgage, and also took the longest to rebuild their scores.
In addition to the differences in score decline and recovery between foreclosure and short sale (without deficiency balance), there is also the further consequence that the deficiency in what was borrowed and what the foreclosure sale yielded creates a debt that follows the home owner for up to 6 years. When a consumer initiates a mortgage on a property, there are two instruments that offer the lender security; the mortgage and the note. The mortgage is the security that links the property to the debt. When a house is sold at sheriff sale, the mortgage instrument is extinguished so the property is no longer security for the debt; however, the note (promise to repay) remains. For example, if you borrowed $100,000 and the foreclosure sale yielded $30,000, the lender can come after you because of the promise to repay in the amount of $70,000. We have seen that begin to happen on a large scale. When your customers approach you about what their best option is, be sure they understand the consequences of their decision. The short sale is the best option for most as it offers limited credit score damage, a shorter recovery period, and for any HUD, Fannie, or Freddie backed mortgages (which covers 90% of homeowners right now) guarantees a release from the remaining debt. On a side note, Fannie & Freddie have a mandate to now respond to short sale requests within 3 days and process a decision within 30 days, as of September 30th.
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