How to Buy Real Estate after a Strategic Default

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A patent attorney.  A certified public accountant. A physical therapist.  A Realtor.  A retired utility company worker.  A mechanical engineer.  A doctor.  A nurse practitioner. An elementary school psychologist.

These are just a handful of people I know that have strategically defaulted on an underwater mortgage.

While their backgrounds and occupations are diverse, all are honest, hardworking and well educated.  Each of them, up until they made the decision to strategically default, paid their bills on time and had superior credit scores.  They all had significant cash reserves and the ability to make payments on their over-inflated mortgage.  But it made no sense for them to continue to throw good money after bad.

U.S. companies like American Airlines engage in this sort of business practice all the time.  Last November, American filed for chapter 11 bankruptcy even though the company had over $4 billion in cash.  American used bankruptcy to trim their debt load and get out of burdensome union contracts.

So why aren’t more Americans walking away from their underwater mortgages?  For starters, lenders have a vested interest in making us believe that it is somehow immoral to purposely default on a mortgage.  If you read my post from last week you’ll find a comment from a lender who claims this course of action is fraudulent.

That is not true.

What is true is that if you elect to walk away from your underwater mortgage you’ll lose the money you put down to purchase the home, any money you spent upgrading the home and your sparkling credit score.  The latter is the other main reason most homeowners continue to pay even though it doesn’t make financial sense.  Most people fear doing a short sale, losing their home to foreclosure, or bankruptcy will destroy their credit score and prevent them from ever buying real estate again.

And that is not true either.  Here are the facts, provided to me by Glen Reiley, a mortgage consultant in Phoenix:

For FHA loans:  a borrower can obtain financing 2 years from discharge or dismissal of a Chapter 7 bankruptcy, 3 years from completion of a foreclosure and 3 years from completion of a deed-in-lieu of foreclosure, short sale or pre-foreclosure.

For conventional loans:  a borrower can obtain financing 4 years from discharge or dismissal of a Chapter 7 bankruptcy, 7 years from completion of a foreclosure, 4 years from completion of a deed-in-lieu of foreclosure, and 2 years after a short sale or pre-foreclosure (with 20% down payment).

Of course, these are traditional bank guidelines.  Very few real estate investors I know use traditional banks to purchase fix and flip or buy and hold deals.  If you’re looking for funding chances are you’ll need to find private or hard money lenders.

Here’s what I learned after my own strategic default – private money lenders could care less about my credit score.  They only care about the purchase price and down payment.  I’m currently working with three different private money lenders and I’m about to start doing business with a fourth.  Security is what they want and with the right buy price and down payment (20-25%) I can borrow up to $2 million dollars at a time.

Sure, their rates are high (from 9.95% up to 18%).  But as long as I’m buying right the profit/cash flow spreads are above average.  The irony here is that drowning on an underwater mortgage will not kill you.  It could actually help you swim again, farther and faster.

(Legal disclaimer: Deficiency laws vary from state to state; always consult an attorney before you consider a strategic default.)

About Author

Marty (G+) is the Chief Financial Officer for Rising Sun Capital Group, LLC, a real estate investment firm based in Gilbert, AZ. His firm purchases homes at the courthouse steps and public REO auctions. They have two exit strategies, either fix and flip or seller financing.

14 Comments

  1. I completely disagree with strategic foreclosure, and I wrote about this in a blog awhile back: http://wp.me/p1dbYY-3v We Americans need to learn how to bring back commitment. These days people just jump from one thing to the next without caring about ethics or morals. It shows in our foreclosure rate, our divorce rate, and a ton of other things in our society. If you enter into an agreement with someone (even if it’s with a bank) follow through with it. The housing market will recovery, and it will recover faster if you don’t walk away from your home just because it’s convenient.

    • Keith, I read your blog post. As I’ve said before here on BP, real estate is a local business. As you pointed out, values in Wisconsin have dropped around 10%. Here in Phoenix we’re down almost 60% from the peak in 2006. It would take someone that bought a house at that time more than 20 years just to get to break even on their mortgage with 4% annual appreciation.

      I’m a committed American, committed to providing a secure financial future for my family. This means making difficult business decisions. And let me tell you, walking away from my house was not convenient. I lost over $150,000 in down payment, repairs and maintenance. Not to mention a severe hit to my 750 credit score. But to continue to make payments would have been unwise.

    • The agreement is if you can’t make the mortgage payment the bank takes the house. What’s the problem? The bottom line is if you were in a similar situation to Marty (You weren’t, I read your blog entry…) what would YOU do? Would you still play the honor and chivalry card while every day you were further and further away from recovering and providing for your new family?

      The bottom line is that if it is ok for the Mortgage Bankers Association to default on their loan, it should be a non issue if a citizen should do the same. It is a truly hilarious double standard.. Here is the Daily Show’s Take on it:

      http://www.thedailyshow.com/watch/thu-october-7-2010/mortgage-bankers-association-strategic-default

  2. You know who was really successful. The folks that took $100,000 and bought a investment property in cash and then later another then another. Other investors might have taken that original $100,000 and turned it into 5-10 investment properties and now have to strategically default. They will say they have a contract with a way out. Its their right to strategically default if they so choose. If its best for them.

    Don’t we see how foolish this is. If a business model makes it such that you have to strategically default (not pay back money you said you would) hen you have a huge flaw in you business and life model. I can’t argue with people who say they would be better off to default. I recommended this to several people years ago. On gal in particular, I told to start a short sale several years ago. She would make foolish life choice after foolish life choice and continue to hold on to a property she could not afford because of the aforementioned life choices. Above that the home was sold at a higher price and has a horrible foundation and is literally better to be leveled and started fresh. She held on and subsequently drained family and friends of tens of thousands of dollars to hang on. Sad. Now she had a less than honest realtor and home inspector and friends and everyone else who enabled her to purchased a home 6-7 years ago. This is no justification but rather a huge glaring lesson to be learned. She needs to understand what home ownership actually entails before purchasing a home. She needed to understand what a home inspector was to look for and why, if you can pull a cinder block from the basement wall and your home inspector says nothing you need a new home inspector and you need to look at yourself in the mirror for being so foolish. You need to understand financing and the RISK that you are taking on. You need to understand what your long term goals are.

    The lessons of this crisis is not to say we can default when its convientient because others are doing it or companies are doing it or it describes some of the process in a contract. No lesson to be learned are how to prevent this from happening again in the future.

    Marty I enjoy many of your posts but I feel you are missing a huge opportunity here to learn from your own personal history in order to justify something you struggled with in your strategic default. I see you dealing with all the effects elhoquently rationally but effects are irrelevant unless you address the causes. You looked back to justify and rationalize but now you need to look back further to fix the initial cause and truly grow from this experience and use your poaition to help others grow. I might be out of line in saying this but I would much rather have you dispise my name and hear it than like me and me not have the courage to say it. There have been much pain and suffering in my life where I would have been much better off if someone came in and slapped me across the face and showed me the error of my ways but instead I learned the hard way by my own doing.

    • Kyle, do you know the difference between someone that put 20% down on a home for their primary residence in 1997 and a someone that put 20% on a home for their primary residence in 2006? Timing.

      If the person who bought in 1997 never refinanced or took out a big line of credit then chances are they are still in their home with a comfortable monthly payment and principal balance.

      The person who bought in 2006 made the mistake of buying a home at the worst possible time in U.S. history. If they live in Phoenix their loan is underwater by more than 50%. The payment is more than double of what their new neighbors, who bought in the last 12 months, are now paying.

      What caused this mess has been well documented – banks who loaned too much and home buyers that borrowed too much. Each are equally culpable and entitled to their own legal means of navigating this disaster. For lenders, it’s government tax-payer funded bailouts and Chapter 11 bankruptcy – for homeowners it’s strategic default.

      • I bought in 2006 and don’t regret it for a minute because I was prepared for no appreciation. But I also bought a fixer upper duplex for my first home to subsidize my payment. I also bought another one in 2007 again not caring about underlying value but rather rental income.

        In the end as I have repeatedly said I don’t have a problem with strategic foreclosures in many circumstances. My focus was not the difference between putting 20% down between 2 different times and markets. I was saying the difference between paying cash just to illistrate the point. Paying cash would mean years of diligent planning and wise financial decisions. This mindset in the masses would not allow the banks to take advantage of people by loaning them too much.

        Leverage is a fantastic tool but only if the investment rises. Now don’t me wrong, I’m far from rich but I realize I am playing with fire everytime I take a loan. I would much rather over estimate risk and limit growth rather than get burnt. There is something about taking on less risk and studying risk with a passion that has allowed me stability and more importantly the confidence to continue to invest and grow with even better results all throughout the downturn.

        Again I agree with the decision you had to make by the position you were in. My only words of wisdom is to study the entire situation to prevent such a decision from having to be made ever again. Thanks again for your response.

  3. I completely agree with the term ‘strategic default’ and have for some time now.

    I know the non-believers have their arguments, but for me, its not worth engaging in that argument. I’d be too busy defaulting, quickly rebuilding and obtaining new properties while the other side is still slowly bleeding on a property they’re too far upside down in.

  4. I am still surprised to see the comments from people like Keith above and others about the morality of defaulting on bad debt. Corporations are allowed to default on debt and “emerge” from bankruptcy and start anew.

    • Yes Sherry, perfectly acceptable in business. I think some get caught up in the fact that the home loan is made to a person, therefore they feel it’s up to the person to repay the mortgage, regardless of the circumstances. Yet corporations get a pass on this. The last time I checked corporations are made up of people too – the CEO, CFO, board of directors, share holders. These individuals choose to default on behalf of the company are praised.

  5. Normally you’d have to wade through 15-20 articles to find the clear information presented in this one. Agree or not, it is a fact that it would be foolish to honor a commitment that would keep your kids from going to college, force you to work two jobs and give up a majority of your life to keep a bank happy. Many people have made the default decision over much hand-wringing and analysis; it ends up being a personal decision in the end.

    The real crime is that there aren’t more posts like this that simply tell it like it is instead of hiding behind the shroud of guilt and honoring big banks.

  6. I want to short sale my home but my wife is making a emotional decision and wants to stay because our kids like living here. We have tried a loan mod. for two years now with no denial or approval. I am hoping that the lender will finally decline our loan mod so that we can move on.

  7. I found this to be a great post, and I can relate fully to your decision. I purchased my first home at the age of 19, and yes I didn’t fully understand what it meant to be a home owner. The facts were that I could afford the home, and it was what I felt I needed at the time. Fast forward a few years and about a 75% decline in value (I’m also in Arizona) I decided it makes sense to strategically default. Was it a tough decision – Absolutely it was, but I couldn’t imagine how tough for someone that has raised their family in their home. Do I regret it- Not one bit, and in fact my only regret is not going into default one year earlier. It has been the best business decision I have made, and wouldn’t you know it I decided to take up real estate investing since that decision.
    Since my default I have made several real estate acquisitions, and sales that could not have taken place had I continued to bleed out payments. It has been 2 years since I defaulted, and in that time I have run my business by leveraging my hard earned cash. I am not a full success as of now; however I am a work in progress. I will quit my day job and take up full time investing this spring, and it is all possible because I made a wise business decision.

  8. This quote is verbatim from FICO’s website: “FICO Labs researchers have found that, as a group, strategic defaulters tend to be more savvy managers of their credit than the general population, with higher FICO® Scores, lower revolving balances, fewer instances of exceeding limits on their credit cards and lower retail credit card usage.”
    After reviewing my personal situation: $200k underwater on $500k balance, (zero down purchase loan in CA never refinanced), 810 credit score, no other debt, stable job, and a bank unwilling to offer any way out of an ARM (they said my salary is “too high” to qualify for refinance), I made the difficult decision to strategically default rather than continue supporting unethical bankers.
    While fully prepared (if needed) to rent for the next 7 years, I’m hoping some savvy (but ethical) investor out there will see that strategic defaulters are actually an EXCELLENT credit risk if the downpayment is big (25 – 30%), and start openly offering us mortgage loans.
    I’d never missed a payment on ANYTHING in my life until the day I stopped paying the mortgage last year. I’m not rich enough to pay cash for a house, but I can come up with a downpayment if I can find a lender. I have not yet seen any mortgage lender advertising to strategic defaulters…..but I’m waiting, and I think America’s entrepreneurs will come through for me.

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