Defaulting on debt is a pretty scary proposition. Whether it’s a credit card, student loans, or a mortgage, failing to pay comes with some serious consequences: damaged credit, inability to open new accounts, and even legal action. Because of this, people will generally do anything within their power to avoid default. But during the financial crisis, that wasn’t always the case.
As Americans watched their home values spiral downward, some made a choice to simply stop paying their mortgages, even when they were still technically able to make the payments. That choice is called strategic default and a recent study from researchers at the New York Federal Reserve suggests why some families utilized this option during the recession: For some, this was actually a smart financial decision, one that helped stave off other, potentially problematic credit problems.
The authors—Sewin Chan, Andrew Haughwout, Andrew Hayashi, and Wilbert van der Klaauw—looked at data and legal proceedings in order to figure out how households dealt with troubled mortgages from 2002 to 2011. They found that borrowers whose mortgages were the most forgiving were the most likely to default. For example, homeowners who were at least 10 percent underwater and who had borrowing terms that didn’t give lenders access to their other assets in the event of a default were 14 percent more likely to default.
During the recession as the number of defaults rose, it took banks longer to make their way through foreclosure process, especially since significant home value loss, default, and eventual foreclosure was often geographically concentrated. The knowledge that actual foreclosure could take a long time also had an impact on the likelihood of default: “Defaulting homeowners can continue living in their homes free of rent payments until the foreclosure process is fully completed and they are evicted from the property. The longer this period of free rent, the greater the incentive to default on the mortgage,” the study found. For those same homeowners, if foreclosure proceedings took nine months or more, they were 40 percent more likely to default.
As home equity declined, default on credit cards and auto loans became less, not more, likely, according to the study. For those who were at least 10 percent underwater, having a loan that protected their other assets decreased credit-card defaults by 18 percent. These borrowers were also less likely to default on their auto loans. This trend suggests that households with significant mortgage debt started funneling income toward other accounts, knowing that ultimately there was a limit to the damage mortgage lenders could inflict.
Interestingly though, a lengthy foreclosure process was bad news for other debt accounts. Those who could remain in their homes for nine months or more between when they stopped payments and when they were actually foreclosed upon were 57 percent more likely to wind up defaulting on their credit-card debt versus those who lived in areas with speedier proceedings that took three months or less. That’s because they faced an immediate reduction in expenses as soon as they stopped making payments, which led to an increased feeling of wealth. This feeling of increased wealth lasted longer for those with who lived in areas where foreclosure proceedings could take a significant amount of time—leaving households less concerned about their need to protect their credit for the period after foreclosure. This result suggests that leaving homeowners in foreclosure limbo is bad for all parties.
The researchers concluded that when provided with protection of their other assets, default on mortgages and efficient foreclosures take the place of defaulting on other debt—a choice that might be useful for former homeowners after they face eviction, allowing them to retain important credit access as they begin the process of moving on.
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