Homeowners Opt to Pay Debts Over Keeping Homes

Seeing few other options, Mendez — who asked us to change her last name for privacy concerns — put her place on the market four months ago. So far, no buyers have showed interest. Even a successful sale wouldn't completely resolve her situation, however: Mendez owes the bank $295,000, while her house was recently assessed at between $200,000 and $230,000. If she sells the place for less than the mortgage amount, Mendez will have to pay the bank the difference. She could try to get the bank to write off that balance, but then she'd owe regular income tax on the forgiven amount. And while the house is still on the market, the bank has refused to work with her on restructuring her loan to lower her payment. In the meantime, she is bracing for another rate reset in November.

Mendez's situation is unfortunately common these days. Over the past three years, plenty of homeowners with lower credit scores or little cash on hand for a down payment bought homes using 0%-down interest-only or other types of exotic mortgages. Now, they are faced with the double-whammy of ballooning mortgage payments and deteriorating home values that too often make their homes financially unfeasible to sell.

In an odd reversal of the American dream, many of these cash-strapped homeowners are now deciding to walk away from their homes. Some, like Mendez, are holding onto hopes of selling. Others are taking more drastic measures, such as voluntarily surrendering their home to the bank with what's known as a "deed in lieu of foreclosure," which transfers the property title to the lender rather than start a foreclosure process. Yet others, perhaps in denial of their plight, are simply skipping mortgage payments until the foreclosure notices arrive.

What's even more perverse is that many of these folks are using whatever money they do have to stay on top of their credit cards and other debts instead of their mortgages.

Consider this: During the first quarter of this year, credit-card delinquencies actually dropped 15 basis points to 4.41% compared with the last quarter of 2006, while home-equity-loan delinquencies were up 23 basis points to 2.15%, according to the American Bankers Association. At the same time, the Mortgage Bankers Association reported that 13.77% of all subprime loans were delinquent in this year's first quarter, compared with a much lower 11.5% in the first quarter of 2006. Even delinquencies for prime loans, which go to those with good credit and solid financials, rose to 2.58% from 2.25% in the first quarter of 2006.

The phenomenon is a historical first, according to Leslie Linfield, executive director of the Institute for Financial Literacy, a nonprofit that provides prebankruptcy counseling. However, given the current real estate environment, she notes, it shouldn't comes as much of a surprise. "When you look at a mortgage payment that went up from $1,500 to $2,500 and a credit-card payment at $500, you have to make a choice," she says. "And if you didn't put a lot of money in your home to begin with, psychologically that was just an expensive rental. So you'll take your credit cards and go get another rental."