Underwater mortgages: When is it OK to just walk away?

Garry Marr, Financial Post · Apr. 9, 2011 | Last Updated: Apr. 11, 2011 9:25 AM ET

Let’s just say you owed somebody a ton of money but there was no legal way to force you to pay it back.

Would you? What if it was one of those evil corporate banks that make for an easy target? Did the answer just get a little easier?

Not for 60% of Americans who say it is never okay to simply stop making payments on your home, according to a survey by Eagan, Minnesota-based findlaw.com, a free legal information website.

Another 34% say it’s okay to walk away from a mortgage but only if you can’t make the monthly payments. Only 3% of believe you should be able to walk away from a mortgage anytime you want, according to the survey which interviewed 1,000 American adults and had a margin of error of plus or minus three percentage points.

It’s an interesting survey given that U.S. law in a number of states allows consumers to simply hand over the keys to their homes without the lender going after their other financial assets -- something that is all but impossible in Canada.

That is not to say that walking away from a mortgage isn’t affecting the credit of Americans who do so. They might not be able to buy another house for years unless they do so with cash.

Despite what the survey says, Americans have been walking away from mortgages in droves because it makes financial sense.

Think about it. You have a home with a $500,000 mortgage on it. The present value of it is $250,000. Why would you not walk away, if you could?

“We just asked people what do you think of the idea, not would you do it yourself or have you thought about doing it yourself,” said Leonard Lee, the researcher behind the survey. “There is a practical argument but there’s a whole philosophical argument.”

If you were shareholder in a company that owned a $250-million building but kept making payments on a $500-million mortgage even though the company had the ability to walk away from the debt how would you feel? Would the executives be breaching a fiduciary responsibility?

The U.S. real estate industry even has a term for all this - strategic default. “You are asking at some point doesn’t it make more sense to walk away from the mortgage where you are unlikely to recoup your original investment,” says Mr. Lee.

Ted Rechtshaffen, president of TriDelta Financial and certified financial planner, says once you put aside the moral issues it would come down to a simple choice.

“It will impact your credit rating but from a financial perspective why wouldn’t you do it? You are getting a $250,000 head start. Another investment is probably going to be better than your current house,” says Mr. Rechtshaffen.

But Benjamin Tal, deputy chief economist with CIBC World Markets, says while it might not make economic sense, there is evidence Americans are not actually walking away from property as much as they probably would if they were listening to a financial advisor.

“Whatever the default rate is now in the U.S., people say it’s 8% and that’s extremely high. I say that’s surprisingly low,” says Mr. Tal.

“You have up to six to seven million households that could default any day, namely because there are in a negative equity position.”

What’s in it for them to keep paying? There is something to say for wanting to stay in your home where you have been raising a family and living. There is also a stigma that comes with somebody slapping a foreclosure sign on your property -- suddenly your neighbours know a little more about your financial situation.

“At the end of the day though, that’s the rational thing to do. You are talking about houses that are under water more than 20%. Based on an economics textbook, that would be the rational thing to do,” says Mr. Tal.

In Canada it’s pretty tough to do. For starters, if you have an insured mortgage, backed by the government, the bank will get paid off for their loan. But the insurance company, whether it’s Canada Mortgage and Housing Corp. or a private insurer, will go after you for any deficiency created by proceeds from the property being less than the mortgage.

It’s the case in most of the country for uninsured mortgages too, says John Turner, director of mortgages for Bank of Montreal. Rules are slightly different in Alberta and designed to protect consumers but Mr. Turner says banks can elect to go after other assets in some circumstances.

There’s also a scenario where you might have bought a condominium as an investment before it was built and put down say 20% payment. If you think you walk away should prices drop by 50% once the building is up, forget it. You’ll be sued.

“As a lawyer we can’t advise someone to break a contract. The law is not you don’t have to obey it, the law is the consequences of not obeying [the contract],” says Calgary lawyer Jeff Kahane. “You haven’t broken the law, you’ve broken your promise. Is it any different than saying why would I want to pay for a chocolate bar at 7-11 when I can put it into my pocket and steal it if I can get away with it.”