Avoid Strategic Default Penalties: What You Need to do Now

In June 2010, Fannie Mae increased their efforts in spreading a public relations campaign that urged against strategic default and discussed the possible penalties of engaging in a strategic default. Fannie May, or the Federal National Mortgage Association, is a mortgage finance broker owned by the government that stated it would soon start taking legal action against debtors who had chosen to leave behind mortgages despite having the ability to pay them. Fannie Mae also indicated it would change the waiting period for borrowers who wished to receive a new loan after they had experienced a foreclosure from five years to seven years. This policy would affect all borrowers seeking new loans after foreclosures unless borrowers could show to their prospective lender that they had defaulted on their initial loans due to fiscal hardship. Borrowers would also have to had contacted their lenders and sought a workout.

What Is a Strategic Default?

A strategic default is when a borrower (for example, someone with a mortgage or another kind of loan) makes a financial decision to stop making required payments to a debt that is still outstanding. There are certain unique aspects to a strategic default: namely, the borrower actually still maintains the financial resources to keep making payments, but has chosen not to. This is the primary difference between a strategic default and an involuntary default.
 

What Is an Involuntary Default?

In an involuntary default, the borrower no longer has the financial resources to continue to make payments on an existing debt. However, if the borrower in an involuntary default had the fiscal resources, he or she would continue to make payments.
 

Why Do Some Borrowers Make Strategic Defaults

Strategic defaults are commonly employed by borrowers when there are substantial drops in property values. An owner of a real estate property may choose to engage in a strategic default when the real estate's market value drops to the mark where the remaining amount the owner owes on the mortgage they took out to obtain the property is now higher than the market value of the real estate property. This is colloquially known as negative equity, or the condition of being underwater. An individual with negative equity may said to be upside down. In such cases, even if the owner continued making payments on the mortgage, they would still face an extremely low chance of being able to recoup equity invested in the property by selling the real estate at a future point in time. Instead of falling underwater, a property owner may decide to stop paying the outstanding debt, resulting in property seizure by the lender, and avoidance of negative equity, or being underwater.

However, strategic defaulters do not typically identify themselves to their lenders as such; they do not reveal that they have simply chosen to stop paying despite having the resources to continue making payments. Rather, they pretend to be involuntary defaulters. From the perspective of a lender, therefore, it may be impossible to distinguish an involuntary defaulter from a strategic defaulter pretending to be defaulting involuntarily. This is why involuntary defaulters must now keep track of the hardships that kept them from being able to continue to make payments on outstanding debts. If they do not, then the lender may assume they were actually strategic defaulters, and levy the aforementioned penalties against them, placing additional burdens on defaulters who were already in difficult financial positions due to truly not being able to make required payments to their lenders.

Implications for Involuntary Defaulters

As a result, individuals who experience an involuntary default must carefully document why they could not pay, or else they may be targeted by new penalties against strategic defaulters, including that described above involving Fannie Mae. The Fannie Mae rule is only one of numerous provisions that have recently been enacted or that will soon be enacted with the aim of penalizing borrowers choosing to engage in strategic defaulting. 

Be sure to keep records of job loss or other major life events that could affect your finances. Major life events that may explain an involuntary default include marriage, divorce, adoption, unexpected medical expenses, job loss, reduced work hours, increased costs of living,  etc.Make sure you keep records of your attempts to work out a loan modification. 

It seems unlikely any regulations will go after homeowners who refused to cash in their 401k to pay a mortgage. But a homeowner who never even tried to sell a second home or expensive car might run into a little trouble. Just be sure you document your attempts to find the assets to stay on top of the mortgage in such cases. If you can show  you would have defaulted sooner or later if things kept going the way they were, you should be okay.

It's too soon to tell how severe or even how enforceable these regulations will be. But you would still be wise to get your paperwork in order now and you won't be scrambling to figure things out when faced with an accusation of voluntary default!\.