What is an Underwater Mortgage?

Owning a home is not just about having a place to live; for many, it's also an investment. However, not all real estate purchases yield the desired financial benefits. In some cases, property values don't...

What is an underwater mortgage? Owning a home is not just about having a place to live; for many, it's also an investment. However, not all real estate purchases yield the desired financial benefits. In some cases, property values don't appreciate, or homeowners fail to build equity at a reasonable rate. This situation, known as an underwater mortgage, can have serious consequences, including financial loss or defaulting on the home loan.

Understanding Being Underwater on Your Mortgage

Being underwater on your mortgage means that the amount you owe on your loan exceeds the fair market value of your property. It's important to note that this calculation is based on the property's value, not the equity you've built up. Even if you've paid off a significant portion of your mortgage, you can still be considered underwater if the property's value is lower than the loan amount. This scenario is sometimes referred to as negative equity or an upside-down mortgage.

Being underwater on a mortgage is not uncommon. In fact, a 2020 study by ATTOM Data Solutions found that 6.6% of all mortgages in the United States were underwater, representing approximately 3.6 million home loans. So, if you find yourself in this situation, remember that you're not alone.

Lenders typically use appraisals to assess the market value of a property before approving a mortgage. However, appraisals have limitations and cannot predict future market changes. They only provide an estimate of the property's value at a specific time.

How Does a Mortgage Become Underwater?

Contrary to popular belief, a homeowner can end up with an underwater mortgage even if they've been diligent in making their payments. It's not always a result of missed payments or failing to reduce the principal balance.

The most common way for a mortgage to become underwater is when the housing market experiences a significant decline in property values. For example, imagine you bought a $500,000 home with a $450,000 loan. If the local housing market subsequently declines, and the property's value drops to $400,000, your mortgage becomes underwater because the loan amount is now higher than the property's value. This situation can happen independently of your payment history.

The aftermath of the 2008 housing crisis serves as a cautionary tale. Many homeowners found themselves with underwater mortgages as housing prices plummeted across the country.

While market conditions are a primary driver of underwater mortgages, missed payments can also contribute to this situation. Falling behind on your mortgage, coupled with the accumulation of interest, can make it even more challenging to recover from an underwater mortgage.

Consequences of an Underwater Mortgage

In most cases, an underwater mortgage doesn't immediately affect your day-to-day life. You continue making your mortgage payments as scheduled, gradually reducing the principal balance. However, certain circumstances can complicate matters.

Taking Out a Home Equity Loan

Homeowners often use home equity loans or home equity lines of credit (HELOC) to finance various expenses. These loans rely on the equity you have in your property. However, if you have an underwater mortgage, there may be limited equity available for you to borrow against. Lenders may even reject your application due to the lack of equity.

Refinancing Your Mortgage

Refinancing your mortgage can be a smart move when interest rates are low. It can reduce your monthly payments and overall loan cost. However, refinancing an underwater mortgage is challenging. Lenders are reluctant to refinance a loan that already has negative equity. Unless you can turn your home loan right side up again, you may be stuck with your existing loan terms.

Selling Your Home

Selling an underwater house can be costly. When you sell a property, the proceeds go toward paying off the remaining loan balance, and any excess is yours as profit (after deducting closing costs). However, since the market value of an underwater house is lower than the original loan, any offers you receive will likely fall short of covering the mortgage amount. Consequently, you'll be responsible for repaying the lender for the remaining mortgage balance out of pocket. This financial loss may make it impractical to sell the property, leading many underwater homeowners to wait for market conditions to improve.

Falling Behind on Mortgage Payments

If your underwater mortgage is a result of missed payments, it introduces the risk of defaulting on your loan, ultimately putting your home at risk of foreclosure. To prevent this, it's crucial to stay on top of your mortgage payments.

3 tips to avoid an underwater mortgage

3 Tips to Help Avoid an Underwater Mortgage

Avoiding an underwater mortgage is preferable to dealing with the consequences. Here are three tips to help you stay financially afloat:

1. Stay Away from Risky Housing Markets

Not all housing markets fare well, and even strong markets can experience declines. To avoid investing in property that may lose value, be cautious when choosing where to purchase a home. Research the housing market and consider its long-term potential before making a decision.

2. Keep Up with Your Mortgage Payments

Staying current on your mortgage payments is the most effective way to avoid an underwater mortgage. By continually building equity in your home, you minimize the risk of ending up with negative equity. While you can't control market conditions, you can prioritize timely payments and reduce the chance of defaulting on your mortgage.

3. Invest in Your Home

Improving your home's value can help safeguard against an underwater mortgage. Consider undertaking home improvement projects such as kitchen renovations, bathroom expansions, or additions. These investments can increase your property's value, making it more attractive to potential buyers. Even if the market is not performing well, your home may stand out and retain its value better than others in the area.

How to Get Out of an Underwater Mortgage

Finding yourself with an underwater mortgage can be disheartening, but there are options to explore:

  • Reach out to your lender: Your lender may offer financial assistance programs to adjust your loan terms. While this is not the same as refinancing, it can provide some relief.
  • Wait out the market: Sometimes, a downturn in the housing market is temporary. Continuing to make mortgage payments and waiting for conditions to improve may be the best course of action.
  • Sell your house (at a loss): If necessary, you could sell your home, even if it means taking a loss. However, you must have the funds to cover the difference between the sale proceeds and your outstanding mortgage.
  • Consider a short sale: In certain circumstances, your lender may accept a short sale. This involves selling the house for less than the outstanding mortgage balance. While this can result in a financial loss, it could be a preferable alternative to an eventual foreclosure.

Can You Refinance an Underwater Mortgage?

In general, lenders are hesitant to refinance an underwater mortgage. However, there are a couple of relief programs available:

  • Freddie Mac Enhanced Relief Refinance: If you have a Freddie Mac home loan and have been making timely payments for at least 12 months, you may qualify for this refinance program. It allows you to pay off the unpaid principal balance, interest, and certain closing costs, effectively starting fresh with your home loan.
  • Fannie Mae High LTV Refinance: Fannie Mae has a similar program called the Fannie Mae LTV Refinance Option. To be eligible, your home loan must be owned by Fannie Mae. This program offers benefits like lower monthly payments, reduced interest rates, and a shortened amortization schedule.

It's worth noting that the Home Affordable Refinance Program (HARP), which was designed for underwater homeowners after the 2008 housing crisis, has expired, with no current plans for revival or similar programs.

In Conclusion

An underwater mortgage occurs when the loan amount surpasses the property's value. It can happen due to market conditions or missed payments. While it may seem challenging to find help for an underwater mortgage, relief programs exist. It's essential to consult a qualified mortgage expert who can evaluate your situation and guide you through the available options. Don't lose hope; there may be a solution that allows you to navigate your underwater mortgage successfully.