The dilemma
Foreclosed homes in Columbus, OH
I suspect there are two reasons behind our survey results. First, the idea of seven years of bad credit just plain scares people. That’s understandable. But it’s worth noting that while foreclosure restricts a consumer’s access to credit and makes borrowing more expensive, it does not cut people off from credit entirely. And don’t forget: living rent-free for two years means plenty of cash in the bank.
Second, I think the crux of the matter is that people feel that walking away from a mortgage is morally wrong. Recent studies back me up. One study by Professors Luigi Guiso, Paolo Sapienza and Luigi Zingales found that 81 percent of respondents believe it’s immoral to default on a mortgage when you can afford to pay it. The key part of this finding is “when you can afford to pay it.”
That’s an emotional or moral judgment – not, strictly speaking, a rational one.
[Resource: Misconceptions May Keep Homeowners From Getting Low-rate Refi’s]
University of Arizona law professor Brent T. White last year published a paper on the influence of emotion on the decision to strategically default. He reports, “if rationality was the driving force, most strategic defaulters would walk away much sooner than they actually do. Instead, most strategic defaulters don’t walk away until they are more than 50% underwater.”
The morality argument
Professors White and Zingales (of the University of Chicago) have been debating this morality question back and forth.
White argues that a mortgage is a contract like any other and the bank makes provisions for defaults, strategic or otherwise. When a borrower defaults, the bank gets to keep the house, the down payment, and everything that’s been paid on the mortgage up until then. He likens it to breaking a cell phone contract to save hundreds of dollars by switching to a different carrier: “Would it be immoral for you to break your contractual ‘promise’… and elect instead to pay the early termination fee?” White asks. “Of course not.”
But Zingales suggests that if strategic default became commonplace, it would devastate the entire housing market.
He writes: “If the underwater homeowners who currently refuse to default changed their minds and decided to abandon their mortgage commitments, the results could be catastrophic. The more people walk away, the more houses get auctioned off, further depressing real-estate prices. This additional decline would push more homeowners into negative territory, leading to still more defaults. Adding to the deadliness of this cycle would be the fact that as more strategic defaults occurred, the social stigma associated with them would lessen.”
The role of the banks … and an alternative »
Image: Louisa Thomson, via Flickr.com
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