What Is A Strategic Default?

This article is an excerpt from the ebook “The Foreclosure Legal Guide.”  You can download a free sample chapter here.

A strategic default is a technique where a homeowner who can afford to make the mortgage payment on their home decides to stop making payments and allow the property to go into foreclosure.  In many cases, the homeowner can afford to make the mortgage payments but has determined that their property has dropped so far in value that it would take years for the homeowner to recoup their investment, leading them to decide to walk away.

In other cases, the homeowner is falling further and further behind and stops paying their mortgage only after they’ve cut back in every other way possible.

The Foreclosure Legal Guide

The strategic default technique has become more popular as real estate values have continued to decline or stagnate across much of the U.S.  Strategic defaults are becoming so popular in fact that 60 Minutes broadcast a story on the practice.  You can view the story here.

The story focuses on Arizona and Nevada, but strategic defaults are becoming just as common in California, where lenders have been extremely reluctant to agree to grant loan modifications or short sales.

Anyone who is thinking about doing a strategic default in California needs to be extremely careful. Under California law, banks may in certain circumstances be able to pursue a defaulting borrower. If a borrower has refinanced their loan, then they generally may be vulnerable to suit by their bank.

In addition, the bank may have up to four years to file a lawsuit against the borrower for the difference between the money loaned out and the amount recouped at the trustee sale.  If the lender files a lawsuit for the deficiency, then the borrower could be forced to spend a lot of money to hire a California real estate lawyer to defend them or to file bankruptcy, even years after “walking away” from the home.

A homeowner who has not refinanced their original “purchase money” mortgage generally is safe from suit, as their loans are non-recourse.

This does not mean that it is a good idea to file bankruptcy immediately after doing a strategic default.  A bank would have up to four years to file a lawsuit for the deficiency, but that does not mean that they will. If the bank does not file a lawsuit within four years, then the statute of limitations expires and the bank has lost its ability to sue you, the borrower.  Assuming you do not have additional debts which necessitate filing bankruptcy, you are “in the clear”.

The next question is whether banks will file lawsuits against the thousands of former borrowers who did strategic defaults. Right now, it is not known what the banks will do.  If the large banks decide to pursue the thousands of their former borrowers, they will need to hire thousands of attorneys to file thousands of lawsuits.  It would clog the courts immediately.

The more likely scenario is that the banks are going to make case-by-case determinations whether to sue their former borrowers. They may decide to write off all loans during a specific time period or in a particular low-income area, or they may do asset searches on all former borrowers to help them determine whether to file suit.

Think About the Short Sale Alternative

If you are thinking about doing a strategic default, but you refinanced your loan(s) at some point after purchasing the property and you are not comfortable with the prospect of waiting four years holding your breath to see if you’ll be sued, then you may want to pursue a short sale.

Traditionally, if you perform a short sale, you could negotiate with the lender to give up its right to pursue a deficiency judgment against you. However, if the lender absolutely refused, then borrowers didn’t have much leverage.

However, a recent change in law has made it easier for borrowers to protect themselves from future lawsuits if they complete a short sale.

In 2010, Gov. Arnold Schwarzenegger signed SB 931, which prohibits a first mortgage lender from filing a lawsuit against you after that lender has agreed to a short sale.  In other words, if a first mortgage lender agrees to allow a homeowner to complete a short sale, the lender will not be able to turn around and later file a lawsuit against that former owner for the difference between the amount owed and the amount the property sold for.

The bill did not protect homeowners in short sales from second mortgage holders.  Even if the second mortgage lender was owed, for example, $100,000, and agreed to accept $50,000 during the short sale, that second mortgage lender can still file a lawsuit against the borrower up to four years after the short sale.

Nevertheless,the bill was a welcome relief to the many thousands of borrowers who have completed or are pursuing a short sale right now.

Want to know more about strategic defaults, short sales, foreclosures, and other options for distressed real estate?  You can read more in the ebook “The Foreclosure Legal Guide.” Be sure to download your free sample chapter.

If you need advice on your particular situation, you may want to take advantage of my firm’s $295 flat-fee 60-minute consultations in person or over the phone.


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