You do not have to lose your home in bankruptcy, but letting go of the underwater mortgage may make financial sense!!
Posted Nov 16 2009 in Wink and Wink by @winkhesaidOne of the most common questions I get as a bankruptcy attorney is whether you can keep you home in bankruptcy. The answer is yes, if you continue to pay the mortgage. However, this may not be the best financial decision.
I recently read a fascinating legal discussion paper out of the University of Arizona Law School that takes an in-depth look at the behavioral reasons which prevent strategic default. Strategic default exists when a homeowner walks away from an underwater mortgage he or she can afford to pay simply because paying it does not make financial sense (that is, they can make more money by renting and investing in something else). The article says people are reluctant to default on their mortgages despite the financial wisdom of doing so because: 1) the idea of foreclosure carries with it shame and guilt; 2) people feel exaggerated anxiety over foreclosure’s perceived consequences; and 3) the government and media contribute to people’s shame, guilt and anxiety.
As a Colorado bankruptcy attorney, I often encounter people who feel this way. They are actually in a worse situation than the strategic defaulter discussed in the paper because most of the people I see can’t meet their financial obligations. Despite this, the feelings mentioned in the article are so strong that these people are still clinging to their home. They know they are in deep financial trouble. They know they are months behind on their loan payments. They know that even with a bankruptcy discharge of their unsecured debt (such as credit card and medical bills) they will likely be unable to stay current on their home mortgage. And despite these realities, they still cannot imagine giving up their home (and the unmanageable payments that often go along with it).
Their question is, “Can I keep my home in bankruptcy?” to which, I say “yes, if you keep up with your mortgage payment.” It’s that simple. But then it’s not.
You see, I can’t stop there. I feel compelled to point out the consequences of this decision, even though most people do not want to even consider walking away from their mortgage.
Why do I do this? Well, as someone with an MBA who has worked in investments, I know how their banker would evaluate this decision, and I want my clients to view their finances in a similar light. I don’t think borrowers should shoulder a disproportionate load of the housing meltdown because of feelings of shame and guilt when the Arizona paper above makes it clear that bankers and lenders not only do not feel these emotions, but seek to profit from people who do!
The financial analysis should compare the value of staying in the home versus the value of renting. The value of home ownership should include home value appreciation at some reasonable level (without regard for irrational hope of returning to where we were in 2006), principal reduction on your mortgage over time as you pay it, and the tax deductions you get for the interest portion of your mortgage payments. On the other hand, the value of renting should include the monthly savings from cheaper rent for a similar home (which seems to exist in almost every situation) as well as some appreciation which could be earned with those savings if you were to invest them while renting.
So, when should you consider giving up your home? When your home is worth less than your mortgage. In such a case, you are underwater and your monthly payment is recovering losses instead of adding to your financial benefit. Depending on how far underwater you are and the cost of renting, you may be better off financially by just walking away.
I find that people have a really hard time with this analysis because they just cannot believe their home is not a good investment. I suppose it took that kind of mentality to push our country to the point where 1/3rd of all mortgages are underwater today and 1/2 of all mortgages are projected to be underwater in 2011. But, make no mistake, these statistics and the fact you are underwater mean you should evaluate the financial sense of continuing to pay your mortgage.
I recently did some analysis for one of my clients in Colorado, where I practice, regarding whether they should keep paying their mortgage. In this case, the client owns a townhome worth $150,000 with a mortgage of $220,000. His monthly mortgage payment plus homeowners’ association dues is $1,675. He could rent a comparable townhome for $1,000 per month.
I looked 5 years out, comparing a scenario where he rented rent for 5 years with one where he pays his mortgage for 5 years. I assumed that both the home’s value and the cost of rent will increase by 3.5% per year during this time (the historical real estate appreciation rate). I also assumed the client could earn 3.5% per year by investing the money he saves from renting versus paying their mortgage. These assumptions reveal that this client could save approximately $37,000 in today’s dollars by renting versus owning a home.
In this case, the client recently lost his job, so he was likely going to default on the mortgage anyway. Because he may need the monthly savings from renting for living expenses, I also ran the analysis assuming that he will not invest those savings. He still comes out $35,000 ahead by renting and not investing the savings. This is because he can rent for cheaper than his mortgage and his mortgage payments will be recovering losses for the next 5 years.
This analysis doesn’t include another important factor in favor of renting. In Colorado, it takes 6 months for a bank to foreclose. During that time, you can legally live rent free. In the case of my client, this adds $10,000 to the savings of renting – more than enough to pay for a bankruptcy attorney and the cost of moving into the townhome up the street!
So, for those who wish to keep their home – YES, you can keep your home in bankruptcy in Colorado if you continue to pay for it and you have $60,000 or less in equity in your home. However, if you are underwater in your mortgage, you should consider walking away. You may find that you can reduce your monthly expenses without impacting your lifestyle. If you just don’t feel right about this, ask yourself what your banker would do in your situation. It’s time to start looking out for your own bottom line!
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