Jeff Horton did a gut check. The 33-year-old information-technology manager had been dutifully making the monthly mortgage payments on his three-bedroom home and on a condo he rented out for investment income, both in the suburbs of Orlando. But he felt trapped. His properties were worth about half of the $395,000 he had paid for them at the top of the market. In September 2009, after months of soul searching, Horton joined the ranks of borrowers who practice “strategic” default: He stopped paying on both mortgages, even though he could afford them.

“I was raised Southern Baptist. The decision was a moral struggle,” says Horton. “My mom had a hard time dealing with it. But I didn’t want to be tied down for five or seven years waiting to break even.”

Breaking a deal. Some 1.65 million homeowners received default notices in the first half of 2010, according to RealtyTrac, an online marketplace of foreclosed properties. It’s impossible to tell how many of those defaults were strategic, but one recent study from credit bureau Experian and Oliver Wyman, a consulting firm, estimates that fewer than one-fourth of homeowner defaults are discretionary. Meanwhile, about 20% of mortgages, or roughly 15 million homeowners, are underwater — they owe more on their mortgages than their homes are worth — and are candidates for default, strategic or not.

Shame, guilt and the anxiety over a foreclosure’s consequences prevent more borrowers from taking the plunge, says Brent White, a law professor at the University of Arizona who has studied strategic default. Plus, as the housing market improves, the default numbers are declining. Homeowners who can’t keep up with payments can pursue a mortgage modification or, if that doesn’t work, a short sale (selling your home for less than you owe on the mortgage with the lender’s okay). Call your lender to negotiate, or go to makinghomeaffordable.gov. Horton says he tried to refinance, but the lender wasn’t interested because his properties had fallen so much in value.

But some view a home purchase as a business deal that you should be able to unwind should it go south. YouWalkAway.com, the San Diego firm that helped Horton with his default, has advised more than 5,000 borrowers about default since 2008. “We want to help our clients avoid bankruptcy, if possible,” says Jon Maddux, YouWalkAway’s co-founder. Maddux says he spends much of his time persuading his customers that they are not bad people for bailing on their mortgages. The site charges a flat fee of $1,000 or offers a trio of payment plans that start at $200 down and $30 per month. For the money, customers receive details on how the default process works and meet with a lawyer and an accountant to discuss legal and financial options.

The fallout. There are benefits to defaulting. While the bank pursues foreclosure, borrowers pay off other debts and save money as they live in their homes free. Horton is reducing his credit-card debt and paying down student loans, as well as contributing $200 more per month to his retirement plan. Given the backlog of underwater properties nationwide, the foreclosure process can take more than a year to complete. It took nearly a year after his last mortgage payment for Horton’s condo to be auctioned off, and as of early August he hadn’t heard from the bank about foreclosing on his home.

But walking away will make it harder to buy a home in the future. Under new rules, Fannie Mae, which backs loans from lenders, prohibits borrowers from receiving government-financed mortgages for at least seven years if they default when they can afford to pay. (You’ll have to wait three to five years after an involuntary foreclosure and two to four years after a short sale.) Defaulting also torpedoes your credit score — at least temporarily. You can expect a 100- to 150-point drop for the foreclosure and extra points subtracted for late payments. A foreclosure can stay on your credit report for up to seven years. But if a default is your only blemish, then you might revive your credit score in as little as two years. Horton says he has seen his credit score drop from 750 to 530 since he defaulted.

Not so fast. Depending on where you live, banks can also pursue a deficiency judgment — that is, they can come after you for the difference if your house is sold in foreclosure for less than the loan amount. About one-third of states prohibit or limit banks’ suing borrowers who walk away. These are known as nonrecourse states. Unfortunately for Horton, Florida isn’t one of them. He owes $140,000 on his condo, which he estimates is worth $50,000. And the home he purchased for $255,000 three years ago was recently appraised for $154,000. He is setting money aside for a settlement with the bank once his foreclosures are final. (Foreclosure laws vary widely by state; check out your state’s laws at www.foreclosurelaw.org.)

Banks have rarely sought deficiency judgments. The risk of a legal action is greater for borrowers who strategically default because they have more money to pay judgments. Yet only five out of more than 5,000 YouWalkAway clients have received judgments, Maddux says. Many others who live in states that allow judgments settle for 20 cents to 30 cents on the dollar. “You are more likely to be hit by a car than a deficiency judgment if you default,” Maddux says.

Banks have been reluctant to sue because it is difficult for lenders to pursue a judgment without spending a lot of time and money in legal fees, according to a recent Deutsche Bank study on strategic defaults. That may change once the economy fully recovers. In many states, a bank can sue to recoup its shortfall four to five years after a foreclosure.

Regardless, Horton is at peace with his default. Once the bank seizes his home, he may rent a house in his neighborhood for half the cost of his mortgage or travel the world with his girlfriend. “But I won’t buy another house anytime soon,” he says.

From Kiplinger’s Personal Finance magazine, October 2010

My wife, Christina, and I watched last year as home prices in Washington, D.C., seemed to bottom out, bummed that we couldn’t take advantage of the generous federal income-tax credits for first-time buyers because we didn’t have enough money for a down payment. Then the credit, which is worth up to $8,000, was extended to first-timers who have a home under contract by April 30.

It’s never a good idea to make a life-changing decision based on a tax credit. But we’ve been talking about making the leap from renters to owners for a while, and we did a gut-check to gauge our commitment. Are we ready for the extra expenses? Yes. In the months since the tax credit was extended, we have put aside enough to cover a down payment and closing costs. Our jobs — and income prospects — are stable. We have good credit and no debt. Can we stay put for the next five years and make a home purchase worthwhile? Sure. Washington has a stable job market and plenty of opportunities for fun.

Our first step was to get preapproved for a mortgage. I thought finding a lender would be the hardest part of the journey, but it turned out to be a snap. We are preapproved for up to $400,000 by two lenders, one of which took less than three hours to decide. We wanted to be conservative in our budget and figured we could afford to pay $3,000 per month to cover the mortgage, insurance, taxes, utilities and maintenance. That’s 25% of our monthly income. The nut we have now will cover a Federal Housing Administration mortgage, which requires a 3.5% down payment, and closing costs. The longer we wait, the more we will have for a down payment.

The search. Just one problem: Although the median home price in D.C. is $306,200, the townhouses on Capitol Hill, where we rent, cost $800,000 — way out of our price range. But we’re committed to staying in D.C. because we enjoy city living and want a short commute to work. To get a three-bedroom home, we’ll have to buy in an up-and-coming (that is, gentrifying) neighborhood. Or we’ll have to settle for a two-bedroom condo if we want to be downtown near a Metro station.

Our home search was initially scattershot. Dots of homes in our price range freckled the Google map, and we perused the online listings. We attended a half-dozen open houses, mainly condos, in several neighborhoods. Most places we looked at had been renovated during the boom with hardwood floors, stainless-steel appliances and granite countertops. However, the condos seemed small for the price and, in some cases, poorly built. The seller’s agents were friendly, but we didn’t know whom to trust.

Paralyzed by the number of choices, we recruited a buyer’s agent. A buyer’s agent usually splits the commission of a sale with the seller’s agent, which worried us because we felt the agent would have an incentive to keep the price high. Ultimately, we decided an agent has more reasons to do right by us than not because the agent is obligated to help us get the best price. Plus, a 10% drop in a home’s sale price would barely dent the agent’s commission, and all commissions would be disclosed.

Colin, the eager agent we picked, has focused our hunt. Using an online service called ListingBook.com, we narrowed the catalog of 300 properties that fit our requirements to a list of 30 homes. It will take time to sort through the housing haystack, and we’ll probably miss the deadline for the federal tax credit. (My feeling is that the credit may have jacked up home prices anyway and, once it expires, prices will drop. Some of the homes on our list have already fallen in price over the past few weeks.) The consolation prize is that D.C. has its own $5,000 first-time buyer’s tax credit (you can’t get both credits). And mortgage rates are still cheap. I think time is on our side.

From Kiplinger’s Personal Finance magazine, May 2010

Our Reader

Who: Rachel Aptekar, 46
Where: Davis, Cal.
Question: Should I use spare income to slash mortgage debt or invest in a 529 plan?

A part-time biology instructor at two colleges, Rachel earmarks $12,000 a year for her family’s future. Her top priority is to save for college for her three children — a commendable goal, but more complicated than it seems. In fact, her solution appears to be to do something unexpected.

Rachel is considering two options: Burn the family’s mortgage by 2013, a year before Laura, 14, graduates from high school, or invest $1,000 a month in college-savings accounts for all three children (including Dylan, 12, and Wesley, 10). With a state-sponsored 529 college-savings account, earnings are tax-free if used for tuition, books, school fees, or room and board.

Retirement is key. Rachel and her husband, Christopher Cassels, first need to review their retirement savings. When college bills come due, kids and their parents can use current income or scholarships, or they can borrow. But you can’t get loans to fund retirement. Christopher, 44, a county government supervisor, contributes to an investment plan for public employees and to a Roth IRA. An extra boost from Rachel would help shore up the family’s retirement security. Plus, Rachel and Christopher could withdraw their Roth contributions tax-free and penalty-free at any time for any purpose, including education.

But there are exceptions, and Rachel and Christopher are that rarest of couples who could own their home free and clear before their children are out of their bedrooms. They have a 15-year loan at a fixed rate of 5%, and they figure the house is worth about $400,000. If Rachel whacks away at the principal with full force, the mortgage stands to be paid off by 2013. Their monthly cash flow would be vastly improved, and they’re not worried about losing a tax break by paying off a mortgage early. They don’t get any tax benefit from paying mortgage interest now because they use the standard deduction — at $11,400 for 2010, it’s bigger than all their itemized deductions combined.

The college angle. The formulas for how much parents are expected to pay for college differ between public and private schools. The federal formula, which governs federal financial aid and public-college awards, does not consider home equity. Many private schools do factor it in, however, so a paid-off house is a disadvantage. Money in a 529 plan can also restrict aid.

Nevertheless, the family should still qualify for some assistance because there will be two, and possibly three, siblings in college at the same time, all being financed on a middle-class income. That situation will count in their favor when it comes to financial aid, especially if the children apply to public colleges.

Bottom line: Rachel should lean toward extra mortgage payments. If all else stays the same, she’ll eventually have $12,000 a year, plus the thousands the couple conserve by not owing on a mortgage, to cover college costs or expand retirement contributions. Less debt equals more flexibility.

From Kiplinger’s Personal Finance magazine, April 2010