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A strategic default is not making payments on a loan on purpose, as opposed to wanting to pay the debt but not being able to. Although both practices have the same result -- not paying back the loan -- a strategic default is more than just semantics. Strategic default is a planned strategy some residential and commercial real estate investors use when they're in a situation that makes it more favorable to default on their mortgage than pay it.
When to consider using strategic default
What usually prompts investors to choose a strategic default strategy is if they owe more on the property than what it's worth, a scenario known as being underwater on the loan. When that happens, many investors choose to stop making payments and let a foreclosure happen.
Other terms for strategic defaults are "walking away," "strategic foreclosure," or "voluntary foreclosure." When borrowers choose a strategic default, they've made the decision to use their cash in better ways than continuing paying toward what appears to be a bad investment.
If an investor is underwater on a loan and having financial difficulties as well, the decision to strategically default becomes a bit easier.
Not all underwater investors default
Not all investors who find themselves underwater on a loan choose strategic default. Some continue to pay the loan, confident the property will be worth more in the future. What currently appears to be a bad investment could prove to be a good one after enough time goes by to let the investment appreciate. Plus, by not defaulting, the investor keeps their good credit, allowing them to make further investments if they like.
What lenders think of this
Banks and other lenders don't like strategic defaults, and they have another name for this practice. They call the borrowers "walkaways" and the act of what they're doing "jingle mail," a reference to the borrower mailing the lender keys to the property instead of the mortgage payment.
The coronavirus caused corporate defaults
Because of financial fallout from the coronavirus pandemic, global corporate defaults reached an 11-year high, and the United States had the most: 146 corporate defaults in 2020. Defaults were highest in the oil and gas industry, with homebuilders and real estate companies in the middle of the pack.
COVID-19-related trouble has also caused investors in the hotel and retail sectors of commercial real estate to stop making payments on their loans. The reasoning is largely due to "bleak prospects for extensions or refinancings when loans come due through next year ," according to a report from Trepp, a provider of data for investment management companies. Multifamily, while not hit as hard as hotels and retail, is also seeing a higher share of defaults.
Consequences of strategic default
Investors who buy residential real estate and default will see their credit score decrease by at least 100 points, making it unlikely to get another mortgage until the incident drops off the credit report, which takes seven years.
However, if the borrower in a strategic default situation takes other steps to better their overall financial picture, such as using the money that would have gone to the mortgage to pay off other debts or investing or saving that money, they may qualify for another loan while the strategic default is still on their credit report.
Investors who buy commercial property will also have a difficult time obtaining credit after a strategic default.
Another problem concerns a deficiency judgment. If a homeowner defaults on their mortgage, for example, whether it's a strategic default or just a default, and the lender forecloses but doesn't obtain enough money from the foreclosure sale to pay the entire debt, the lender might be able to come back to the borrower for the deficiency. If banks can get a deficiency judgment against the borrower, they can garnish wages or a bank account to get their money.
There could also be a tax hit to an investor who strategically defaults. If the bank forgives any deficiency after a foreclosure sale, the IRS might count that forgiven money as income and tax it.
Alternatives to strategic default
Homeowners have options besides a strategic default if their property is underwater and they don't want to continue paying the loan. They can see if the lender will allow a short sale. However, borrowers might still be subject to a deficiency judgment in this scenario.
A deed in lieu of foreclosure is another option. This happens when the lender agrees to take the house back. Again, borrowers could be subject to a deficiency judgment with this option.
A third option is to see whether the lender will agree to a loan modification to make the payments more affordable.
The Millionacres bottom line
Whether to use strategic default is a personal decision. Some people believe it's morally wrong to not pay back a debt you can afford to pay, just because it better benefits you to default. But others believe you need to put yourself first when it comes to business. Before you consider a strategic default, think about all the ramifications, and make the best decision for you.
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