Increase in strategic defaults may be helping the economy

The first wave of U.S. mortgage defaults is now history and since 2007 few are unaware of its impact on the U.S. economy. Primarily spurred by lenders who made bad loans and borrowers who sold “up” to that bigger home, with larger monthly payments. Lately, something altogether different has been making an increasing contribution to soured debt: Americans choosing to stop making mortgage payments they actually can afford.

A recent report suggests that “Strategic Defaults” accounted for at least 12 percent of all defaults in February, up from about 4 percent in mid-2007. A strategic default is defined as a homeowner who hadn’t previously been delinquent, but then skipped payments for three consecutive months; and stayed current on other consumer debt of $10,000 or more.
Housing analysts say strategic defaults mainly occur when a home’s value has dropped below the balance remaining on the mortgage. A homeowner in that position may decide that continuing to make payments is throwing money away, or may default to get the lender to re-negotiate the terms of the loan. An estimated one in five U.S. homes with a mortgage has “negative” home equity, according to

In March the Obama Administration announced it was coming up with a plan to encourage cuts to the principal on mortgages exceeding the worth of properties. Previous government efforts did not emphasize principal reduction but focused on lowering monthly payments. Still these programs are confusing and only aid a few who qualify for the specific guidelines. This does not address the millions of homeowners who tried to modify their own loan only to be declined. Often the principal reduction is a smoke screen because the interest rate remains high so the interest that is paid back ends up being more than what a low rate modification would be. For people staying long term, it doesn’t make sense, but for those who just want to find a way out of their home in the next year, it may serve them well. That is assuming the value doesn’t continue to decline.

Whatever you think of strategic defaults from an ethical point of view, they appear to be temporarily aiding the economy, by boosting consumer spending and allowing homeowners to stay current on their other bills. Consumer spending, which accounts for about 70 percent of economic activity in the U.S., rose at a 3.6 percent pace last quarter, more than economists forecast. The increase, the biggest since 2007, was somewhat puzzling considering that the underemployment rate was at 16.9 percent in March, near the highest level in 16 years. (The rate includes people without jobs, part-time workers who would prefer a full-time position, and people who want work but have given up looking.)

All told, borrowers who aren’t making mortgage payments equates to $100 billion annually, an amount of 1% of the US economy. “Presumably these homeowners know they’re going to have to start paying again” to live somewhere, because delinquencies on credit cards and auto loans have been dropping. This may be a sign that homeowners are using mortgage money to pay down other debt, which is great. Maybe many of us have really learned our lesson and now understand that debt literally robs us of our freedom!

The paradox is a little disconcerting because by helping to boost the economy now, and affecting their credit which dictates future ability to borrow…what happens when that boost is gone?

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