What if you’re upside down in your home?

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It doesn’t seem like you’re getting ahead if the values of both your home and portfolio are going backward.

The stock market has certainly tested the mettle of Americans in the last 15 months. Declining home values are even tougher to take. Some 16 percent of American households — one out of six — are underwater, according to Moody’s economy.com. Among those who bought a home in the last five years, nearly a third (29 percent) owe more on their homes than they are worth, according to Zillow.com.

Having negative equity is like walking on a treadmill with an injured knee. You don’t get anywhere, and it’s painful. If you’re lucky enough to be financially solvent, that puts you in the enviable position of being able to make the house payments, even though it feels like you’re throwing hard-earned money into an abyss.

Below, we look at the predicament of a typical family. The “Smiths” are making payments on a house that lost one-third of its value over the past three years. We then ask three Certified Financial Planners for solutions, which they provide in their own words.

Meet the Smiths

John and Sandy Smith, in their late 30s, are current on their house payments. They married last year. Sandy has a daughter, age 12, from a previous marriage. Near the market peak in 2005, Sandy purchased a two-bedroom/two-bath condo in lovely Boca Raton, Fla., for $225,000. It seemed like a good buy at the time.

Because John and Sandy married, they discovered that the space in the 1,500-square foot condo is not optimal for a family of three, so they put it on the market eight months ago. Their asking price is $199,900 — significantly less than what Sandy paid for it.

John and Sandy’s real estate agent held an open house on two consecutive Sundays recently. No one showed up — not even a nosy neighbor.

Their asking price is not low enough. Several neighbors have since put their condo units on the market, with asking prices ranging from $145,000 to $290,000. (John says the latter figure is way too high because no units have ever sold for that much).

A handful of units have sold since January; their listing prices ranged from $150,000 to $175,000. Three sold for in the neighborhood of $150,000. A fourth sold for $132,500. Some of the sellers owned their units for a very long time, so they sold at a profit, John says.

John and Sandy would like to move into a larger home, especially since prices have fallen. For a while they considered buying a second adjacent unit in their condo complex, but have since changed their minds. It would require a big investment to combine the two. They also considered buying a place and then renting it out, but are having second thoughts. “I think the only thing worse than having one house with negative equity would be having two,” John says.

The mortgage amount is $190,000. The condo unit was financed with a hybrid adjustable rate mortgage with a 6.5 percent rate for the first seven years.

Says John: “Since getting married, the extra storage needed along with dual incomes and lower home values have made moving into a larger home more desirable. Unfortunately, it seems next to impossible to unload our condo for an amount that is anywhere near what we owe. In the end, accounting for our negative equity, buying a house today is as expensive for us as it was three or four years ago.”

What are John and Sandy’s options? See what three financial planners have to say.

Michael Kitces, CFP, weighs in

Pinnacle Advisory Group

Columbia, Md.

Unfortunately, there really is no magical solution for this. The basic options available are relatively straightforward:

1) Reduce the asking price, and sell the condo for the best they can get. To the extent that the net proceeds after selling costs are less than the mortgage, they may need to make up the cost to the mortgage company by bringing additional cash to settlement. But at least this will get them out from under the current mortgage/property, and give them the capacity to purchase a new property. Of course, any payment they make to rectify the negative equity on the current condo would diminish the down payment they would have used for a new property!

2) Buy a new property, and try to rent the old one. Whether this is feasible or not will depend on a few factors, particularly whether it is even feasible to rent the current condo, and whether they can get enough rent to cover at least the mortgage, condo fees and other expenses of the property.

In addition, this is really only an option if John and Sandy have enough income to qualify for a loan to buy a new property (not to mention having enough for a down payment), while still maintaining the old mortgage. If this is an option, then once the equity balance is positive on the old condo, they can try to sell the property. Of course, it’s worth noting there’s a risk that waiting could just make the negative equity problem worse if the property declines further in value!

(Editor’s note: HOA bylaws stipulate that residents can only rent a condo six months in any 12-month period, according to John. So renting the old condo is not an option.)

3) Stay in the current condo, and manage as best they can. This is obviously not the most desirable option, but it may be the best and the most economically feasible. At the end of the day, if John and Sandy cannot afford to pay off the negative equity balance (not to mention have a down payment for a new home, and qualify for a new loan in today’s much more restrictive lending environment), then this is really the only option available. Of course, it’s obviously not what John and Sandy want, but sometimes the best possible advice is for someone to just sit tight, keep making payments and saving, and wait for a better opportunity down the road.

I do NOT recommend for John and Sandy to simply try to abandon their current home to the lender since it’s underwater. Doing so can destroy their credit rating, and may make it almost impossible to get a new loan for many years into the future. If they were to go down this road, it would virtually guarantee that they will not be able to get a new loan for a new larger home. It is hoped, it’s not even a consideration, but with more stories arising of people trying to get out of their negative equity position by “just mailing the keys to the lender,” I think it’s worth noting that this is NOT a recommended course of action.

Advice from Mari Adam, CFP, MBA, CRPC

Adam Financial Associates

Boca Raton, Fla.

John and Sandy have what is becoming a very common problem in our area — negative equity in their real estate. This is really a time to keep your head screwed on straight and think rationally through the options. Otherwise you can get yourself in big trouble.

This does not mean that they are insolvent (e.g., they are not in the same category as people facing foreclosure), but it does limit their real estate options.

Their goal is to upgrade to a larger, more family-friendly property. Depending on their personal circumstances, they’ll have a few different options.

1) They can stay in the unit and not upgrade. This is the easiest solution but comes at the price of not achieving their goals. They have an adjustable mortgage, but the rate is reasonable and it does not adjust for a few more years. That gives them time to save more money, pay down the mortgage, and wait for the real estate market to improve.

2) Try to sell the unit and move. This will be hard because they cannot do a short sale (it would damage their credit and prevent them from buying again). So, if they sell, they need to pay off their mortgage. This may involve a bigger loss than they can afford.

3) Rent the unit — probably the best choice. They can rent until the sales market improves. Hopefully, they will have enough cash to put down on a new house and can qualify for a second mortgage. This would help them achieve their goals and take advantage of today’s much more reasonable prices to buy.

(Editor’s note: This is not an option for John and Sandy because of homeowners’ association restrictions.)

I agree with John — it would not be a good idea to buy a second condo. This does nothing to get them closer to their goals, and condos are the weakest link in the chain.

They should sit down and review the terms of their adjustable mortgage right away. When I ask clients what exactly their mortgage terms are, few know. You cannot make good decisions without knowing this info cold. When does it adjust, how much can it adjust, what is the benchmark, where do I find that info, and how much would it be if it adjusted today?

The bad news is: The real estate situation is very tough for many people. The good news is: There are huge opportunities out there if you have some financial flexibility and good credit. Let’s hope John and Sandy can take advantage of today’s prices to buy the house they now need!

Feedback from Leslie T. Corcoran, CFP

Family First Financial Planning

Stuart, Fla.

My first thought is to get a professional organizer and see if they can’t make do with the space. I have used one quite a bit and she really has made me see that my house can really hold our family of six and all their belongings once you pare down all that extra junk!

They could buy a new home and try to rent the condo, but they would have to recognize what their rental income would be versus the cost/hassle of renting. (It could result in a negative cash flow for a period of time.)

(Editor’s note: This is not an option for John and Sandy because of homeowners’ association restrictions.)

They could sell the home and accept the loss and hope that they make it up in the long run on their new home. They should ask themselves: What are the benefits financially as well as emotionally of doing so?

Note that a larger home not only costs more to buy but also costs more to run and manage. Have they considered what the additional monthly expenses will be with a larger home? Add yard work, pool maintenance, etc.  Plus a new home means new furniture, new decorating, etc.

I would rather keep my overhead low and wait for the market to correct itself. A family of three can live in a two-bedroom condo just fine. Plus they can use the extra money to save more for retirement, college, family vacations, etc. They can just walk away from the condo for a long trip without those worries about grass cutting, home maintenance, etc.

It comes down to wants versus needs to me. The most successful people are the ones who keep overhead to a minimum. Debt enslaves the borrower. If they stay put, they can pay off their debt quicker, save more, and then in that situation have more choices in life later on. I have seen too many people feel they must have that bigger house and then get way too deep in debt. Plus housework, yard work, cleaning, etc., takes time away from family.

Written by
Barbara Whelehan
Contributing writer
Barbara Whelehan is a contributing writer for Bankrate. Barbara writes about a range of subjects, including homebuying, real estate, retirement, taxes and banking.
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