4 dangers of walking away from a mortgage (© Giantstep Inc./Getty Images)

© Giantstep Inc./Getty Images

Some homeowners who are "underwater," or owe more on their mortgage than the home's current value, are turning to "strategic defaults" in which they simply walk away from mortgage debt.

But financial experts warn the cost of skipping out on mortgage debt can be high.

The American Bankers Association recently informed homeowners about the consequences of strategic default, including the possibility of the bank obtaining a judgment to pursue the homeowner's assets, such as bank accounts, cars and investments. (Bing: Which states allow deficiency judgments?)

Here are four dangers of which homeowners should be aware and more information on the strategic-default environment.

1. Wrecked credit
Regardless of whether a foreclosure is because of a strategic default or other circumstances, it damages a consumer's credit score.

"A foreclosure is one of the stronger predictors of future credit risk," says Craig Watts, public-affairs director of FICO, a credit-rating company.

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Foreclosures remain on a credit report for as long as seven years, with the impact gradually lessening over time. Watts says FICO scores "generally begin to recover after a couple of years," assuming the consumer stays current on all payments and other credit accounts.

He says the impact of a foreclosure on a credit score depends on other factors in the borrower's credit history. The ABA says a foreclosure drops a FICO score by 100 to 400 points.

2. Difficulty getting new mortgage
A voluntary foreclosure also can affect a homeowner's ability to qualify for a new mortgage for years to come.

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Peter Fredman, a Berkeley, Calif., consumer attorney, says Fannie Mae and Freddie Mac will not approve a mortgage for four years after foreclosure, while the ABA says it can take three to seven years to qualify for a new mortgage.

In addition, Fannie Mae this past summer announced a tough new sanction on people who deliberately default on their mortgages. These borrowers will be ineligible for a new Fannie-backed mortgage for seven years after the foreclosure date.

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3. Taxes still due
Tax liability is another potential danger of defaulting.

Although the Mortgage Forgiveness Debt Relief Act of 2007 offers protection from federal taxes after a foreclosure through 2012, state taxes still may be due on unpaid debt.

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4. Deficiency judgment
A lender can also pursue the remaining debt from an unpaid loan by obtaining a deficiency judgment against the delinquent borrower, or it may work with a collection agency to recoup losses.

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Ethical questions also surround strategic defaults. A survey by Trulia.com and RealtyTrac found that 59% of homeowners would not consider defaulting, no matter how much their mortgage was underwater, although the other 41% of homeowners said they would consider a default.

Less risky in some states
Despite the potential negative consequences of a strategic default, the move is less risky in some states than in others.

"The first question for anyone considering a strategic default is whether the homeowners will be liable for the debt anyway," Fredman says. "Each state has different rules."

Nonrecourse laws protect homeowners in some states. According to research from the Federal Reserve Bank of Atlanta, the 11 nonrecourse states are Alaska, Arizona, California, Iowa, Minnesota, Montana, North Carolina, North Dakota, Oregon, Washington and Wisconsin.

When a borrower defaults in one of these states, the lender can take the home through a foreclosure but has no right to any other borrower assets. Home-equity loans are ineligible for this protection unless they were used as part of the home purchase.

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In some areas, lenders are so overwhelmed with defaulting customers that homeowners can live in their homes for free for a year or longer before the foreclosure is complete.

The average length of time from default to eviction is 400 days in California, Fredman says.

Price of freedom
The potential consequences of strategic default cannot deter some homeowners from taking the plunge, says Frank Pallotta, executive vice president and managing director of the Loan Value Group in Rumson, N.J.

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"While everyone understands the credit-score impact of a strategic default, most borrowers don't seem to care," Pallotta says. "They think a 200-point hit on their credit score cannot offset the benefit of living for as long as 18 months rent- and mortgage-free. They see strategic default as a form of financial freedom, especially if they live in a nonrecourse state and know someone who has done this."

Fredman, who developed the Should I Pay or Should I Go online calculator to help consumers evaluate a strategic default, says homeowners considering a strategic default should research tax laws and state regulations about loan defaults. Even nonrecourse states' laws can affect defaulting borrowers, he says.

"I also think everyone should consult an attorney and probably an accountant, too, because the relative cost of these professionals is not nearly as high as the potential cost of making a mistake," he says.

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