Strategic Default

Strategic default occurs when a borrower intentionally stops making payments on a debt, despite having the financial capacity to do so, often because the borrower believes that paying off the debt is not financially beneficial. This tactic is common in real estate when the value of the property securing the debt falls below the outstanding loan balance (i.e., when the property is “underwater”).

Examples of Strategic Default

Example 1:
Jane purchased a home for $400,000 with a mortgage. Over a few years, the market declines, and the home’s value drops to $300,000. Jane still has a $380,000 balance on her loan. Although she can afford the mortgage payments, she decides to stop paying because the property is significantly underwater.
Example 2:
Mike owns a commercial property financed with a $1,000,000 loan. Market conditions change, reducing the value of the property to $700,000. Despite having tenant income to cover the debt service, Mike opts for strategic default to renegotiate better terms or let go of the now unfavorable investment.

Frequently Asked Questions about Strategic Default

What is a strategic default?
It is the intentional cessation of debt payments by a borrower who has the financial ability to pay but chooses not to, usually because the collateral’s current value is significantly less than the outstanding debt.
Can lenders pursue borrowers for the outstanding debt after a strategic default?
Yes, but it depends on whether the loan is recourse or nonrecourse. With a recourse loan, the lender can pursue a deficiency judgment to recover the balance. With nonrecourse loans, the lender can only take the collateral.
How does strategic default affect a borrower’s credit score?
A strategic default can significantly negatively impact a borrower’s credit score and may hinder their ability to obtain future financing.
Is strategic default legal?
While legal, strategic defaults are often seen as unethical. Borrowers should carefully consider the legal and financial consequences before proceeding.
What are deficiency judgments?
A deficiency judgment is a court order that allows a lender to collect the remaining loan balance if the foreclosure sale price does not cover the total debt owed.

Foreclosure: The legal process by which a lender attempts to recover the balance of a loan from a borrower who has stopped making payments by forcing the sale of the asset used as collateral.
Nonrecourse Debt: A type of loan secured by collateral, usually real estate, where the borrower is not personally liable for the debt beyond the collateral.
Creditworthiness: A valuation performed by lenders that determines the potential risk of lending money to borrowers.
Deficiency Judgment: A judgment by a court against a borrower for the outstanding balance on a loan after foreclosure sale proceeds fall short of the amount owed.
Negative Equity: A situation where the outstanding debt on a property exceeds its current market value, often referred to as being “underwater.”

Online Resources

Investopedia - Strategic Default
Consumer Financial Protection Bureau (CFPB) - Loan Modification Scams
The U.S. Department of Housing and Urban Development (HUD) - Avoiding Foreclosure

References

Investopedia. “Strategic Default.” Investopedia, Strategic Default Definition.
Consumer Financial Protection Bureau (CFPB). “Loan Modification Scams.”

Suggested Books for Further Studies

“The Big Short: Inside the Doomsday Machine” by Michael Lewis
“House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again” by Atif Mian and Amir Sufi
“Foreclosure Investing For Dummies” by Ralph R. Roberts

Real Estate Basics: Strategic Default Fundamentals Quiz

### What is strategic default? - [ ] Selling a property below its market value. - [ ] Investing in high-risk properties. - [x] Stopping payments on a debt despite having the ability to pay. - [ ] Acquiring new debt to pay off old debt. > **Explanation:** Strategic default is the intentional cessation of payments on a debt despite having the financial ability to make those payments. ### Which type of property is often involved in strategic default? - [x] Properties with underwater mortgages - [ ] Properties fully paid off - [ ] Newly constructed properties - [ ] Rented properties with no mortgage > **Explanation:** Strategic default commonly occurs when the property's value is less than the owing loan amount, rendering the property underwater. ### What immediate consequence can borrowers face after strategically defaulting? - [ ] Increase in property value - [x] Foreclosure proceedings - [ ] Gain in current property equity - [ ] Reduced property tax > **Explanation:** After strategically defaulting, borrowers usually face foreclosure proceedings initiated by the lender. ### How does strategic default affect your credit score? - [ ] It has no impact. - [x] It can significantly decrease your credit score. - [ ] It might temporarily improve your credit score. - [ ] It increases your score over time. > **Explanation:** Strategic default can significantly decrease the borrower's credit score and impair their ability to obtain future credit. ### Can a debtor always avoid liability for the leftover debt balance following a foreclosure? - [x] Only in the case of a nonrecourse loan - [ ] Yes, in all cases - [ ] Yes, if agreed with the lender - [ ] No, always liable > **Explanation:** With nonrecourse loans, the lender can only claim the collateral and the debtor is not personally liable for any remaining balance post-foreclosure. ### Strategic default is ___________? - [ ] Only recommended by financial advisors - [ ] Never affecting personal financial records - [x] Often seen as unethical - [ ] Encouraged by lenders > **Explanation:** Strategic default is often seen as unethical despite being legal in many cases. ### Why might someone choose strategic default? - [x] Financial burden of maintaining a property with negative equity - [ ] Desire to buy a new property with better terms - [ ] To avoid paying property taxes - [ ] To improve their credit score > **Explanation:** Individuals choose strategic default to avoid the financial burden of maintaining a property whose market value has dropped significantly below the mortgage owed. ### What should Jane consider before deciding to strategically default? - [ ] Potential to purchase another property immediately - [x] Legal and financial implications including deficiency judgments - [ ] Options for refinancing her mortgage - [ ] Incentives offered by the lender > **Explanation:** The borrower should consider the legal and financial implications, such as the potential for a deficiency judgment, before opting for strategic default. ### Which of the following is often a motivating factor behind strategic defaults? - [ ] High likelihood of property appreciation - [ ] Strong job market - [x] Significant negative equity in the property - [ ] Low mortgage rates > **Explanation:** The significant negative equity, where the loan amount exceeds the property's current value, is often the motivator for strategic default. ### What legal remedy might lenders seek for recovering unpaid balance after a foreclosure? - [ ] Strategic default - [ ] Bankruptcy relief - [x] Deficiency judgment - [ ] Nonrecourse Note > **Explanation:** Lenders may seek a deficiency judgment, which is a court order for the remaining unpaid debt following a foreclosure sale of the property.

Strategic Default