Millions of Americans, whose homes are now worth significantly less than their mortgage, could be making an expensive mistake by continuing to try and pay their loan off when they should, instead, be walking away. In fact, owners are willing to keep piling money into a losing investment simply because they're ashamed to foreclose, according to a controversial new study.
"Homeowners should be walking away in droves. But they aren't," writes Brent White, an associate professor of law at the University of Arizona.
He explains that some owners who bought at the peak of the market now owe more on their mortgage than they can ever recoup in their lifetime. Although it would make financial sense to cut losses and abandon their homes, feelings are getting in the way. "A lot of it has to do with shame, guilt and fear," says White.
Critics say advising someone to walk away from their home is irresponsible.
But White argues that the math is simple.
In his paper he runs through average scenarios in two states and shows how some middle-class homeowners could save more than $300,000 in just ten years by foreclosing, even after factoring in costs.
White made his case in a study entitled "Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis," which was published in the latest issue of Arizona Legal Studies.
In some parts of the country, including Arizona, California and Florida, home prices have fallen by more than half, while rents have also dropped, White says. As a result, if you bought an average-priced home in 2006, it's likely that your mortgage payment is significantly more -- by up to three times more -- than the cost of just renting a similar home in your area.
But Americans don't care about the math.
"Going through foreclosure is an admission of failure," says Jeremy Tobacman, an assistant professor of business at The Wharton School in Pennsylvania. "People like to fulfill their obligations.
Afraid to Foreclose
In addition, homeowners have an exaggerated fear about the consequences of foreclosure -- a fear that is fueled by banks, White said. He says many Americans mistakenly believe foreclosing on a home will irreparably damage their credit score or cost them more than they can afford.
More than 15 million Americans -- a whopping third of all homeowners -- are currently underwater, which means their home is now worth less than their mortgage, but only 4.5 percent are in foreclosure, according to latest figures from the Mortgage Bankers Association.
Not surprisingly, few industry insiders agree with White's findings. They say foreclosure should be a last resort taken only after pursuing all other options, including modifications and short sales. Adam Pedowitz, spokesperson for the Distressed Property Institute, which trains real estate agents in selling distressed homes, says foreclosure has negative implications for an individual's credit score, tax liability, even the ability to find a job.
"It's irresponsible for anyone to advocate that employed homeowners should walk away from their mortgage -- a contractual obligation -- simply because their home is temporarily worth less than the purchase amount," says Sarah Tinsley, a spokeswoman for the Mortgage Bankers Association. "Nobody benefits from foreclosure."
White says Pedowitz and others in the industry are using "scare tactics" and argues that the consequences are not quite as dire. If you start with good credit and continue to meet your other credit obligations, you can restore your rating to above 660 in as little as two years following the foreclosure. White says you can even qualify for a federally-insured FHA loan to purchase another home within three years. And, he adds, Congress has waived tax penalties for foreclosures until 2012.
Taking a Loss
The foreclosure process, meanwhile, typically lasts a few months and costs less than $10,000.
Pamela, an executive recruiter in Madison, Wisc., who asked that her last name be withheld, says she prefers to sell her home at a loss rather than foreclose.
After a divorce, two lawsuits and a drop in business due to the recession, she's having trouble making her mortgage payments. The value of her condo has dropped by more than a third in the past two years. The developer started liquidating vacated units in her building at fire sale prices to pay off debts. Pamela considered going into foreclosure, but instead, plans to sell her condo and eat the loss.
"There's a bit of pride there," she says. "I'd be embarrassed if I foreclosed on my home."
It's not just embarrassment that's to blame. Americans believe strongly in the value of homeownership, even if owning one's home – as opposed to renting it – is more expensive.
"Homeownership is … an extension of self; if one owns a part of a country, one tends to feel at one with that country," Robert Shiller, a Yale professor and widely respected real estate expert, wrote in an op-ed piece in the New York Times last year. "Policy makers around the world have long known that, and hence, have supported the growth of homeownership."
Of course, there's nothing wrong with wanting to fulfill one's obligations. The American work ethic, handed down by Puritan ancestors, is built on a strong commitment to duty. But when those on the other side of the contract – lenders – are acting on a different set of norms that requires them to maximize profits instead, homeowners end up bearing the brunt of the cost, says White.
"There's a double standard," he says, pointing out that banks have received trillions of dollars in bailout money to help them minimize their losses. "A corporation would walk away in a New York second from an underwater mortgage."
To make matters worse, many Americans who are so far behind on their mortgage payments that they have little hope of ever catching up, are still trying to make their payments. Some take out more credit card loans or cut back on essential spending.
With little regard for their personal circumstances, lenders continue to demand payments, even when they know the owner will foreclose eventually.
"I see it all the time. Lenders try to sneak by," says Darren Hamm, a housing counselor at Neighborhood Housing Services of Greater Cleveland, who helps owners negotiate loan modifications and foreclosures. "Even if you're behind, they try to get you to repay it as if you could catch up. But they're just stacking the deck."