“Imagine a homeowner who purchased a house several years ago that has now dropped one-third in value. His income has also fallen, so payments are difficult to meet, and he’ll soon have two children in college. He thinks walking away from his mortgage — intentionally defaulting — may make economic sense for his family. But he also feels ethically obligated to honor his commitment. What should he do?”
Lawrence Kalbers: This is a relevant and difficult question for millions of Americans. The drop in home values has left many homeowners with negative equity, sometimes called being “underwater” (i.e., the market value of the home is less than the loan balance). In May of this year, Zillow, the online real estate database, estimated that more than 31 percent of homeowners with mortgages were underwater. Zillow also reported that 90 percent of those who are underwater are current on their payments. Locally, the counties of Los Angeles, San Bernardino and Kern had underwater percentages of 32, 53 and 60 percent, respectively. In LMU’s ZIP code, 90045, the figure is 16 percent.
Let’s call our imaginary homeowner Mike. Some would argue that Mike clearly faces an ethical issue and that he should honor the commitment that he made — end of story. Others would tell Mike that this is nothing more than a financial decision. If it makes economic sense, Mike should walk away — no ethical dilemma here. In fact, numerous pundits and companies today are proponents of “strategic defaults.” This concept primarily applies to people who can afford to continue to make payments but choose to go through default as the best financial option.
A Sense of Duty
Motivation is a primary consideration in resolving ethical dilemmas. Mike may be motivated by his “sense of duty” to pay based on legal, ethical or religious perspectives regardless of other factors, including the consequences of his actions. It is simply the “right thing to do.” The sense of duty can be seen in Immanuel Kant’s categorical imperative or psychologist Lawrence Kohlberg’s fourth stage of moral development, which is described as the desire to follow laws and maintain social order. Even if Mike’s loan is underwater, it appears that he can make his mortgage payments, but it would make life easier if the payments were lower. Though keeping his commitment is inconvenient, it is certainly not impossible. Should we keep our commitments only if they are easy? That is surely a slippery slope and a weak sense of duty, at best.
We may also ask to what lengths Mike should go to honor his commitment. Should he continue to make payments regardless of the consequences to him and his family? Continuing to pay the current mortgage may negatively affect Mike’s ability to pay for his children’s college education and make things tight financially. Selling the house and moving to another location, perhaps to take a better job, may also be difficult. If Mike defaults on his loan, there also are negative consequences to him and others. Obviously, the lender would not get all of its money back. If everyone who is underwater defaulted, it could contribute to a further decline in home values and perhaps further dampen the nation’s economic recovery.
The Down-side and Up-side
For Mike, the consequences may include significant damage to his credit score, liability for the amount of the loan not recovered by the lender (this may depend on the state in which Mike resides), potential tax liability for any forgiven debt, the inability to buy another home for some period of time, possible bankruptcy and the stigma of walking away from the loan. On the positive side, walking away may be less expensive for Mike than making the payments. If Mike continues to make the payments, recovering the negative equity in his home could could take years, or decades.
So, what should Mike do? While it would be easy for Mike to rationalize this as merely a financial decision, or decide he entered an “unfair” game in a housing market that was fraught with greed, and even fraud, there appears to be no specific coercion or fraud involved in Mike’s purchase of his home. Mike, I recommend that you honor your commitment and stay in the 90 percent of those underwater who continue to make their payments.