There seems to be a debate between whether it is ethical to strategically default on your home mortgage.  Where I personally land on the issue is probably irrelevant, but if you promise to read to the end you’ll get your answer as to what I believe.  If you walk away from your credit card debt what happens? Does it go away? Nope.  What about if you default on your student loans? Nope they don’t go away either.  What about your auto loan? Nope, they repo and can still come after you for the difference.  So how is it that homeowners can participate in a short sale or strategic default and not receive a judgment against them?

What is a Short Sale?

As most people are aware a mortgage is “a debt instrument that is secured by the collateral of specified real estate property and that the borrower is obliged to pay back with a predetermined set of payments.”  In other words you are taking on a loan which is secured by a note which is usually amortized over a certain amount of years, and since that note is secured by a piece of real property if that note is defaulted upon then the property will be the first thing taken.

There are three scenarios when you decide to foreclose on your home,

  • If you owe $500,000 on your home and your house is worth $500,000…the bank takes the house back and everyone walks away with a fake smile.
  • If, however, you owe $500,000 on your home and the house is worth (and ultimately sold at auction for) $1,000,000 then the bank must provide you with the surplus
  • But what happens when you owe $500,000 and your home is only worth $350,000? Who is on the hook for that extra $150,000?

That shortfall is what creates the term, short sale; the term, which was once a taboo subject, now is common place.  The National Association of Realtors provides a very basic and intuitive definition of a Short Sale,

A short sale is a sales transaction in which the seller’s mortgage lender agrees to accept a payoff of less than the balance due on the loan.

While the definition of a short sale is that simple, it is the repercussions that occur afterwards that differ State to State.

Is My State a Recourse or Non-Recourse State?

There are different remedies afforded to lenders who are securing the note with a piece of real property used as a residence as compared to an unsecured line of credit or even an auto loan, and these remedies differ state from state.  From About.com,

Recourse loans get their name from the fact that lenders have power. They are allowed to go after you for amounts that you owe – even after they’ve taken collateral. If you default on a recourse loan, the lender can bring legal cases against you, garnish your wages, and try to collect the amount you owe.

A legal action to collect money after foreclosure is generally called a deficiency judgment

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A non-recourse loan does not allow the lender to pursue anything other than collateral. For example, if you default on your non-recourse home loan, the bank can only foreclose on the home. They generally cannot take further legal actions against you. The bank is out of luck even if the sale proceeds do not repay the loan.

Non-recourse loans create the most risk for lenders. Because they can only collect the collateral – and nothing else, they want to see lower loan to value ratios to reduce their risk. These loans may have higher interest rates than recourse loans.

Is any of this news to the bank? Nope. If they are licensed to sell mortgages in the State, then they’ll know whether they are providing a loan in a recourse or non-recourse state.  Do you know who is usually clueless? The mortgagor-borrower.

How do you determine if your State is a Recourse or Non Recourse State? I would check with a licensed attorney.  That may seem like a “cop-out” but every resource that I have come accross on the Internet while researching this post, doesn’t seem to list every State, or is just plain wrong.  You should also be able to check your mortgage documents.

This post was inspired by a comment from Crystal from Budgeting in the Fun Stuff (who freely rips on me for hating on teachers)  on a post from Little House on the Valley