10/06/2011 06:55 pm ET Updated Dec 06, 2017

Pay the Mortgage or Default? It's Becoming a Game of Musical Chairs

In 2008, walking away from a severely underwater home was the ideal financial choice, in hindsight. In 2012 it may not be, because banks are starting to knock down the principal in some cases. This is about the leading trends.

Had people known the perfect game plan for an underwater home back in 2008 -- when few of us knew the perfect game plan -- it would have been:

  1. Stop paying the mortgage.
  2. Live rent-free for 12-24 months.
  3. Sock the saved mortgage money into savings.
  4. Negotiate a 0% interest rate on credit cards, and then pay them down as quickly as possible.
  5. Maintain an immaculate payment record on everything (except the house, of course), and a good credit utilization ratio.

Your credit report would then show a foreclosure and 2-3 missed credit card payments (as you stopped credit card payments to negotiate the 0% interest rate).

Today, over three years later, your FICO score would be back up above 700, you would have money for a down payment, and by early 2012, when housing prices should hit bottom, you would be in a perfect position to buy a nice house at its true value. Call this Formula #1.

Alternatively, if you didn't want another house, you could have stopped payment on credit cards too, and been in a much better cash position today, with a FICO score approaching 700, if you still cared. Call this Formula #2.

Moving on from the woulda-shoulda-coulda department, Formula #1 will work today -- if housing prices stay low for a few years to come. (Formula #2 still works, period.)

But there's a curve ball to Formula #1: the bank might knock down the principal owed on the house to the current real market value ... the one simple, solid deal that a bank has to offer an underwater homeowner who wants to stay in the house. To someone who bought the home because they wanted to live there -- meaning most homeowners -- that's about as sweet a deal as you can get.

(Reducing the interest is usually meaningless, because you are still buying an underwater house. And reducing the monthly payments is a farce, if the bank is going to tack the balance on to the tail end of the mortgage.)

What we can be fairly sure will not happen is a mass government bailout of homeowners, such as is being discussed in Ireland. In Ireland the cost of a bailout is estimated at US$6 billion (serious money in a country of 4.6 million people), but in the U.S. it would need far over a trillion dollars.

So not everyone is going to get a principal knockdown. Instead it will be a game of musical chairs: principal reductions for some and not for others. Who will get the reductions?

The FHFA is under pressure from public interest groups and start knocking down principal on homes, but so far there have been few principal reductions through the HAMP program (and the HARP program does not do principal reductions, they only work with interest rates and juggling monthly payments).

"FHFA has been a real obstacle to community stabilization on a number of fronts," says Kevin Stein, Associate Director of the California Reinvestment Coalition. "They need to let tenants stay in their homes and change the loan modification policies at Fannie and Freddie."

Unfortunately, if the Feds take action, it may be the same type of actions that leave many strapped middle-class people frozen out of food stamps or medical benefits -- they may be cash-poor, but their assets on paper exclude them from the programs.

The mortgage bankers themselves will probably be more predictable, as they move from sniffing pixie dust to acting faintly rational -- if they are actually holding the note. (When mortgage banks have flipped the note, they're no longer lenders -- just "servicers," making money on the clerical tasks of bookkeeping.)

Here is a clear candidate for principal reduction, followed by an informed guess.

The clear candidate is the one that has already happened, when Chase bank unilaterally started knocking down principal owed on option ARMs in Florida, as reported by the New York Times on 7/2/2011. The NYT story reported Bank of America as doing the same in some circumstances.

(That particular article, however, describes option ARMs which are about to shift into hemorrhage-payment rates -- not fixed-rate loans at the slower bleeding rate of the monthly vampire visit.)

The guess: the possibility is the one that credit analysis companies have recommended to lenders: cut deals with the exact people who fit the original strategic defaulter profile of:

  • Underwater home
  • Excellent credit
  • Perfect payment history
  • Enough cashflow to pay the mortgage without dipping into savings

Banks don't seem to be acting on this yet. But as the inevitability of Underwater America defaulting sinks in, these will probably be the people they approach first -- though I'd guess they will initially approach well-off mortgage-holders with reduced interest payments offers, rather than actual principal knockdowns.

So at best guess, you might want to consider hanging in there if:

  1. Media is reporting that your lender is reducing principal for people in your exact circumstances, in your state.
  2. You fit the profile of the original strategic defaulters. If you don't hear from the lender pretty soon, my guess is that your best option is not to stop payments -- instead, I would try stopping by the lender in person, and calmly inquiring about loan modifications. This will give the desk person a chance to pull up your account on the screen, look at your credit score and perfect payment record, and think "Oh, oh! The profile of a strategic defaulter!" Maybe the branch will contact you in a few days. Or it may not.

Otherwise, defaulting on a severely underwater home sooner rather than later is probably still the best move for you and your family.

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