One of the major distinguishing factors between a strategic default and any other mortgage default is that a strategic default is a deliberate business decision. The homeowner has the ability to make payments but simply decides not to because the property value is less than the balance owed on the mortgage.
These defaults take lenders by surprise as borrowers often have excellent credit histories and meet all of their other financial obligations.
Considered a viable strategy for managing troubled assets in an era of record foreclosures, high unemployment and government bail-outs, millions of Americans are considering strategic default or strategic foreclosure. With almost 28 percent of all mortgages underwater, a growing number of homeowners are contemplating walking away from their home.
While borrowers are contemplating strategic default, lenders are seeking predictive indicators to prevent them through advanced credit scoring technologies.
A dynamic three-digit number reflecting an individual's ability to repay, credit scores are assigned by companies like Fair Issac and Company. They play a critical role in determining whether a borrower is eligible for a loan, the loan amount, as well as interest rates and repayment terms.
Fair Isaac, creator of the widely-used FICO score, recently introduced an enhanced version of its popular scoring model, the FICO 8 Mortgage Score. This model will make it for most consumers to secure mortgage loans.
The FICO 8 Mortgage Score has been enhanced to better anticipate consumer behavior amid a foreclosure crisis and tough economic times. With this product, FICO has fine-tuned their predictive powers to assist lenders in determining which borrowers are likely to strategically default.
According to a recent Experian-Oliver Wyman Market Intelligence Report, strategic defaults rose 53 percent in the first half of 2009, to 355,000 foreclosures. Previous studies found that 588,000 strategic defaults occurred in 2008, double the level that took place in 2007.
"Many borrowers are being advised to stop paying their mortgages," said Carlos Reyes, a foreclosure defense attorney with the Reyes Law Group in Fort Lauderdale. "Making the decision to simply walk away is bad for the homeowner. Borrowers should consider their rights and contemplate the long ranging consequences of such an action."
Researchers have found that home value and principal amount play a role in strategic defaults, but that there are also other distinct character traits that identify potential defaulters making this decision. Strategic defaulters typically have higher FICO scores, lower revolving balances, fewer instances of exceeding the limits on credit cards and lower overall retail credit card usage.
In fact, their behavior is almost opposite to those of distressed defaulters. Strategic defaulters default "because they believe it is in their best financial interest, and because they believe the consequences will be minimal," says FICO Labs head and FICO chief analytics officer Andrew Jennings.
Furthermore, they plan ahead for the hit they will take when they default, opening new credit cards and arranging for housing before they "do the math and walk."
Claiming to save in excess of $1 billion by helping to prevent 115,000 foreclosures, FICO officials indicate their new model is 15 percent to 25 percent more accurate in predicting strategic defaults than its predecessor.
"The FICO 8 Mortgage Score's broad availability means that all U.S. lenders and servicers can now easily access scores that are fine-tuned for mortgage performance," said Jordan Graham, executive VP of Scores and president of Consumer Services at FICO. "Moreover, by combining this superior predictive performance with the FICO Economic Impact Service, lenders are able to adjust policies and strategies quickly based upon forward-looking economic modeling. This is what we mean by the FICO analytic advantage: the ability to use the most advanced predictive analytics to compete and win in this highly challenging environment."
Strategic default may seem like "walking away" from a bad debt, but it can have long ranging consequences. Absent a deficiency judgment, you will certainly suffer in the form of lower credit scores and a drastically curtailed ability to secure future credit.
Higher interest rates and unfavorable terms could end up costing more in the long run than continuing to pay on an upside-down mortgage.