Wednesday, June 25, 2008

The Effects of Negative Equity on Foreclosure

From a paper recently published by the Federal Reserve Bank of Boston:
Millions of Americans have negative housing equity, meaning that the outstanding balance on their mortgage exceeds their home’s current market value. Our data show that the overwhelming majority of these households will not lose their homes. Our finding is consistent with historical evidence: we examine more than 100,000 homeowners in Massachusetts who had negative equity during the early 1990s and find that fewer than 10 percent of these owners eventually lost their home to foreclosure. This result is also, contrary to popular belief, completely consistent with economic theory, which predicts that from the borrower’s perspective, negative equity is a necessary but not a sufficient condition for foreclosure. Our findings imply that lenders and policymakers face a serious information problem in trying to help borrowers with negative equity, because it is difficult to determine which borrowers actually require help in order to prevent the loss of their homes to foreclosure.
I think this makes a very important point that I have believed throughout the mortgage crisis. People don't just walk away from a home because their mortgage balance is more than the value of their home. The reason is that most homeowners have an emotional connection with their home. They love their home.

In addition, not only is moving a big hassle—especially if you have lots of stuff—but for parents it potentially means taking their children out of their school and away from their friends. Homeowners tend to go into foreclosure only when they have negative equity and can no longer afford the payments.

One caveat with the above study is that the late-80's bubble that this research is based on is minuscule compared to the bubble that exists across much of the U.S. today.

Hat tip to Calculated Risk.

I'm curious to know what readers think. If you owned a home with substantial negative equity, would you walk away from it even if you could afford the payments?


  1. Yes, If my credit would not tank. I bought in 07

  2. In general, it would make little sense to walk away from a home due to no other reason than negative equity.

    In walking away, a homeowner stands to lose: If by walking away we mean selling the house even if it's at a loss, it is plenty obvious that this choice is nonsensical. If on the other hand, by "walking away" we mean that we choose to stop paying the mortgage and let the bank repose and sell the home, the poor logic would depend on whether a state where this property is located holds homeowners responsible for the portion of the mortgage that is still outstanding after the repo or sale has taken place.

    But I can see one instance in which choosing to walk away could make some sense: If the property is located in a neighborhood which might see overall property value declines for some time in the future; in other words, if the property is located in an area that will be unlikely to see any type of gentrification or urban renewal in the near future. Then, walking away would make sense: you cut your loses now, rather than wait a bit more and thus exposing yourself to bigger loses.

    But that's just the opinion of someone with little practical experience in the real estate business.

    --ssn anon

  3. I wouldn't stop making payments on my house even if I was really upside down. This is because I have a family (wife and 9-month-old daughter) and we like the neighborhood we live in. We think we have a pretty good quality of life.

    There is also another reason why we wouldn't stop making payments: I am a financial analyst. To get a job as an analyst, you need to make sure your FICO score is good. If I walked away, my FICO score would turn into crap and I could forget about getting another job until my credit was repaired.

  4. It is better to wait it out and in the long run your house will be worth more. It is always better to own real estate than to rent.

  5. If you walk away, generally you are not responsible for the remaining debt. You just lose your collateral—the house. However, it does hurt your credit.

  6. negative equity borrowers and those who took out suicide loans -- 2 or 5 year ARMs and/or neg-am, are largely coincident populations, and this population is much, much larger 2004-2006 than in the 80s.

  7. Depends on the state, in California you can walk away without getting a deficiency judgement. In Florida the lender can come after you for any deficiency on the foreclosure or short sale of your house.

    Do a short sale rather than a foreclosure. I'm told your credit would allow you to get a home as soon as 2 years after a short sale versus 5 years after a foreclosure.

    I'm a Tampa Realtor and I have clients who have a 2nd home that they planning to move to and trying to get a short sale on their current primary residence. The $100k+ negative equity is the main reason why they're selling. Plus they do not have to worry about qualifying for a new mortgage because they already have one on their second home. I've seen owners actually buy a 2nd home before doing a short sale on the current home.

    There are tax implications if you cannot prove you are "insolvent" so you have to consult an experienced Tax advisor first. The lender may send a 1099 to the IRS and report an ordinary income of $100k or more depending on your situation. That could be a hefty tax bill.

  8. In Calif. you will not be responsible for the remaining debt on a 1st mortgage. Not sure if it's true on a HELOC, it's probably collectable. In Florida, you will have a deficiency judgement and they can go after any other assets you have.

    I'm told doing a Short Sale will allow you to get a mortgage after 2 years. A foreclosure will require you wait 5 years.

  9. Very thoughtful post. This make me think about it again.

  10. No one is exempted from the risk of foreclosure. Unexpected events - the sudden loss of job, a sickness or death in the family, divorce – are all serious situations that can cause foreclosure. More than this, ineffective handling of finances or uncontrolled spending can also lead to foreclosure. Read the effects of foreclosure to your life.