Strategic defaults are becoming more common.

They work like this: The borrower owes $250,000 on a home that’s now worth $200,000. They stop paying the mortgage, but it takes the bank six months to a year to foreclose and evict the borrower. Meanwhile, he or she pays no house payments and the bank absorbs the negative equity.

The drawback for the borrower is damaged credit and the possibility in some states that the bank will sue for a deficiency judgment.

Paola Sapienza, a professor of finance at Northwestern University and an expert on strategic defaults, points to what he calls the “contagion effect.” As the practice gets more common, the stigma declines and more people say, “Look I’ve done it, and I’m fine.”

Source: St. Louis Post-Dispatch, Stephen Deere (09/12/2010)

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