Underwater Mortgage: Know Your Options

What causes an underwater mortgage?

When you owe more on your mortgage than what your home is worth, it’s known as an underwater mortgage. Another name for it is an upside-down mortgage or having negative home equity.

There are a couple of scenarios that can cause an underwater mortgage.

When home values decline

A declining housing market can cause an underwater mortgage. This is when the home values drop in general, and you’re unable to sell your home for enough money to cover the remaining mortgage.

For example, assume you bought a home for $300,000 two years ago. You put down a $60,000 down payment and used a mortgage loan to cover the remaining $240,000. At the time, you had a mortgage appraisal to get approved for the loan, and the appraised value came back at $240,000.

Fast-forward two years later: The housing market is not as robust as it was, and homes in the area have started selling for a lower amount. If a current home appraisal shows the value as lower than your outstanding loan balance, then the mortgage is underwater.

Thankfully, while this scenario was likely familiar to homeowners during the housing crisis, it’s not as common in the current marketplace.

"In today's transformed housing market, the prevalence of underwater mortgages has significantly diminished since the housing crisis of 2009. … The dynamics have shifted, and the occurrence of such situations is now super uncommon," said Alex Shekhtman, the CEO of LBC Mortgage, a broker based in Los Angeles.

If you fall behind on mortgage payments

Another cause of underwater mortgages is falling behind on mortgage payments. When you make payments toward a mortgage in the early years of the loan term, most of the monthly payment is going toward interest — not the principal.

By missing or falling behind on mortgage payments, you allow more interest to accumulate because the principal is staying the same. The owed interest compounds, which can make it even more difficult for you to “catch up” on payments, thus putting you upside down on the mortgage.

Risks of an underwater mortgage

An underwater mortgage is not an ideal financial scenario for any homeowner for several reasons:

• Decreased chance of refinancing: When a mortgage is underwater, it virtually eliminates any chance of refinancing without using a government-backed loan. Lenders look at equity when assessing the risk of a buyer, so not having any equity makes it much riskier for the lender.
• Negative equity: The negative equity in an underwater mortgage means you will owe money at closing if you sell the property. This may put a huge financial strain on your finances, as it limits the amount you can put into another property, savings or paying off debt.
• Difficulty selling the property: It may be more difficult to sell, since you are responsible for any balance of the mortgage that isn’t covered by the sale.
• Risk of foreclosure: If the payments become too much or you are unable to sell the property, you may fall further behind, putting you at an increased risk of foreclosure.

» MORE: What is preforeclosure?

How to know if your mortgage is underwater

An underwater mortgage occurs when you owe more than your property is currently worth. You can use your loan-to-value (LTV) ratio to understand whether your mortgage is underwater.

The LTV ratio represents the amount you owe on your mortgage compared to the amount of your property’s value. An LTV above 100% means you owe more than your home is worth. A mortgage may be considered seriously underwater if the LTV ratio reaches 125% or more, meaning your mortgage balance is at least 25% more than the value of your property.

You can calculate your property’s LTV ratio by dividing your current mortgage balance by the appraised property value, then multiply the result by 100.

For example, if you owe $275,000 on a home worth $250,000:

$275,000 / $250,000 X 100 = 110% LTV

In this case, the mortgage is underwater because the LTV ratio is above 100%.

To calculate your LTV, you’ll need an estimate of your home’s value in today’s market. To find this, you can:

• Check recent sales in your neighborhood and ZIP code.
• Use an online home value estimator tool for a general idea.
• Get a professional home appraisal for an accurate valuation.

» MORE: Low home appraisal: why it happens and how it can affect your refinance

What to do if you have an underwater mortgage

A number of options are available to those with underwater mortgages.

Keep paying

One option if you’re upside-down on your mortgage is to stay put in the home and continue to make payments. Not only does this build equity against the loan principal, but it gives the market time to rebound, and you could possibly benefit from increased values at a later time.

“Homeowners can find solace in the fact that even if their property value temporarily declines, their primary responsibility remains fulfilling their mortgage obligations,” said Shekhtman. “The focus for homeowners should be on diligently paying down their mortgage and patiently awaiting the appreciation of their property's value over time.”

If you decide to stay in your home, consider making extra principal payments whenever you’re able. Extra principal payments reduce your mortgage balance faster, which can help you build equity in the home and take steps toward getting your mortgage above water again.

Loan modification

Loan modification is when a lender changes the loan terms on a permanent basis, ideally making it easier for the borrower to make payments and avoid possible foreclosure. The lender may extend the length of the loan, reduce the interest rate or offer forbearance for part of the loan balance.

A mortgage lender that offers this option will likely use a “trial period” to ensure you can make the new payments, but bear in mind this option may extend the length of your loan or add a large balloon payment to the end.

Refinance

Although refinancing is much more difficult when you’re in an underwater mortgage, it is still a possibility for some homeowners.

If you have an existing Federal Housing Administration (FHA) loan and are current with your payments but are underwater, you may qualify for an FHA streamline refinance. The advantage to this option is it requires little underwriting or documentation, although there may be high costs tacked onto the loan.

There are also similar programs, like the Freddie Mac Enhanced Relief Refinance Mortgage and the Fannie Mae High LTV Refinance Option, but both programs are currently paused.

Sell or rent the home

Selling the home is an option if you’re dealing with an underwater mortgage. This has its drawbacks, as it could mean a large out-of-pocket expense at closing if you’re unable to sell it at a price to cover the existing mortgage.

This balance might not include the other numerous expenses associated with selling a home, including closing costs and moving expenses.

You could also rent the home and use the rental income to make extra payments toward the mortgage. However, this may not be an option if you don’t have another place to live.

Short sale

A short sale is an option for those who want to sell their home. A short sale is when the lender accepts an offer to purchase the home for less than the remaining mortgage balance.

Sometimes the lender will forgive the difference in price. But other times, the homeowner must make debt settlement arrangements for the difference, and the short sale will impact the borrower’s credit. Although it is a loss for the lender, it’s likely a less expensive alternative than a foreclosure.

Foreclosure

Walking away from the home and allowing the foreclosure process to take place is another option, although it comes with many disadvantages. A foreclosure means the bank takes possession of your home and sells it to recover loan funds.

Foreclosure can have a devastating impact on your finances. It shows on your credit report for seven years, making it difficult to qualify for another mortgage or other loan. Strategically defaulting on your mortgage and allowing foreclosure to occur should be a last resort only after exploring other options like selling the property, refinancing or negotiating with your mortgage lender.

Bankruptcy

Declaring bankruptcy is another alternative but, like foreclosure, it will significantly impact your credit and other aspects of your finances.

A Chapter 7 bankruptcy wipes out debt obligations, including a mortgage, but it means you can no longer stay in the home. A Chapter 13 bankruptcy may allow you to keep your home, but there may be a loan modification during the bankruptcy process for the remainder of your mortgage balance.

The consequences of bankruptcy follow you for a long time, staying on your credit report for up to 10 years. It may keep you from purchasing another home or qualifying for other types of loans.

FAQ

Bottom line

Underwater mortgages are concerning because of the financial impact if you need to sell your home or use your home equity for other financial reasons. However, there are options available to homeowners, including loan modifications or a short sale.

While it’s not an ideal situation, if you’re having trouble making payments, then the most important step is to reach out to your lender or service provider as soon as you can so you can work together to find a solution.