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What is a Strategic Default?

Article Details
  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 14 October 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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A strategic default is a financial decision made by a borrower to voluntarily cease making payments on an outstanding debt. This type of strategy is unique, in that the borrower does have the resources on hand to continue making payments if he or she wishes to do so. For this reason, a strategic default is very different from an involuntary default, where the debtor lacks the financial ability to keep making payments, but would do so if he or she had the resources on hand.

One of the most common situations in which a strategic default approach may be employed is when property values fall substantially. Assuming that the market value of the real estate reaches a point where it is lower than the remaining amount owed on the mortgage used to acquire the property, the owner may choose to default on the mortgage loan. This is because even if the owner continues to make payments, the chances of being able to sell the real estate at a later date and recoup the equity in the property is extremely low. Rather than create a situation where negative equity exists, the owner simply chooses to stop making payments, allow the property to be seized by the lender, and thus avoid incurring the negative equity.

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If the borrower has other pressing debts, the use of a strategic default may be viewed as a means of diverting financial resources to settle those other obligations while still remaining in residence on the property. Depending on the local laws that apply, it may take the lender anywhere from a few months to a couple of years to formally complete foreclosure on the property and evict the borrower. If the debtor is able to pay off all other debts during this time, and accumulate resources to secure another place of residence by the time of the eviction, he or she may actually be in a better financial state than if the intentional default never took place.

In many jurisdictions, the use of a strategic default is not without some sort of consequences. At the very least, the default will result in a negative influence on the borrower’s credit rating that will have an impact on the ability to borrow funds for acquiring other property. Some jurisdictions also allow lenders to seek further redress from the borrower once the foreclosure is complete and the property has been sold at current market value. Those laws make it possible for the lender to seek redress for the difference between the amount of the default and the funds recouped by the subsequent sale after the foreclosure. In some nations, the difference between the value of the property at the time foreclosure proceedings began and the amount remaining due on the mortgage is considered forgiven debt by tax agencies with jurisdiction in the area, resulting in tax debt for the borrower.

Along with the legal and financial ramifications of a strategic default, there is also an ethical element that may have a lasting impact. Simply put, lenders who note that a prospective borrower has used this method in the past may feel that the degree of risk involved is too great to approve the loan application. This may be true even if the default occurred many years previous, and the borrower currently has an excellent credit rating. Others feel that the use of a strategic default under certain circumstances is a prudent option and that no breach of ethics is involved.

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