Walking away from an underwater mortgage doesn't guarantee a fresh start

House floating on blue water

A woman I know is thinking about walking away from her deeply underwater home.

Some of you may find this story familiar.

My acquaintance — let's call her Sally — bought her house in California at the top of the market. Since then, her home has lost almost half of its value.

Sally, like most people, didn't see the collapse of the housing market coming. She also didn't foresee the two children she and her husband now have.

She wants a financial fresh start and a larger home that is more appropriate for her family.

But with so much negative equity, Sally doesn't have the option of doing a traditional move-up purchase.

So she's thinking of just handing her keys over and walking away, finding a rental and starting to save for a down payment, even though she'll take a temporary hit to her credit score. This type of foreclosure is called a strategic default.

With this plan, Sally faces some big pitfalls.

Sally lives in one of the states that doesn't allow lenders to sue homeowners who default. So she believes she's in the clear.

That's not necessarily the case.

In a number of states that restrict lawsuits, the restrictions only apply to first mortgages used to buy a home, says Loriann Harrison, a broker-associate and certified distressed property expert with Keller Williams Realty.

"That means that most home equity loans, HELOCs and other liens are considered recourse loans, and lenders for these loans may sue borrowers for the loss," Harrison says.

She recommends homeowners consider a short sale first.

A short sale can be a more attractive alternative than walking away from an underwater mortgage, Harrison says, because it doesn’t have to be disclosed on future mortgage applications.

With a short sale, it may be possible to get a new mortgage after two years, sometimes less, compared to five to seven years for a foreclosure.

The problem with a short sale is that the bank has to agree to one. If you’ve been making your payments and are still employed, the bank doesn’t have much incentive to approve the transaction.

The next-best option is to offer the bank a deed in lieu of foreclosure, says agent Deb Tomaro of RE/MAX Acclaimed Properties in Bloomington, Ind.

Again, getting a lender to write off debt from a paying borrower seems unlikely.

My acquaintance’s bank has been nothing but rude to her when she’s called to discuss her options. The bank’s behavior is only fueling her desire to walk away.

But no matter how she feels about her bank, there are other considerations.

Home prices and interest rates could stay low and keep her plan on track.

But either or both could rise and put a new home out of reach, leaving her stuck in a rental.

In an expensive real estate market like California’s, even a small interest rate increase means a significant bump in monthly house payments.

The cost of renting is another issue.

"In many markets, the cost of rent is comparable, if not higher, than mortgage payments, so it's not realistic to think that someone will stockpile a huge sum of money because of not being burdened by a mortgage payment," Tomaro says.

A poor credit score from the foreclosure could mean that landlords wouldn’t want to rent to her or would require her to put down the maximum deposit allowed by law.

A foreclosure could even hurt her or her husband's job prospects. Employers who consider credit reports in hiring might take a pass on someone with a foreclosure on their record.

Their current jobs could even be placed in jeopardy.

“For police officers, military and others who are in financially sensitive positions that require security clearance, employment can be revoked or terminated due to foreclosure,” Harrison points out.

If Sally does choose to walk away, she should get professional help.

Each state is different, and the laws regarding foreclosures and short sales are always changing, so homeowners facing foreclosure should seek both legal and financial counsel, Harrison says.