Some homeowners who are underwater — meaning they owe more on their mortgage than their home’s current value — turn to “strategic defaults” in which they simply walk away from the debt. The cost of skipping out on a mortgage, however, can be high.
What is an underwater mortgage?
When the current value of a property is less than the amount owed on the mortgage, the loan is said to be underwater. In other words, an underwater mortgage has a higher outstanding principal balance than the market price of the home. This circumstance is also referred to as being “upside down” or having “negative equity” in the home.
Homeowners with little or negative home equity can find themselves in this situation when property values fall, even when they’ve made all of their mortgage payments on time.
How to tell if you’re underwater on your mortgage
1. Find your mortgage balance
Check your mortgage account online or review a recent paper statement for the unpaid principal balance. This is the amount you still owe on the mortgage.
2. Get an estimate of your home’s value
To find out how much your home is worth, begin with online research. Type your address into a search engine and compare different estimates on real estate websites as a starting point. Then, search for recent sales of similar homes near you and see how much they sold for. For deeper insight, you can also contact a local real estate agent and ask for their opinion, or hire an appraiser to get a professional valuation.
3. Subtract your mortgage balance from your home’s value
If the amount you owe on your mortgage exceeds your home’s estimated value, you’d be considered upside down on your mortgage and should begin to carefully assess your options. If you owe $150,000 on your mortgage, for example, but your home is worth only $100,000 in today’s market, then you’d be underwater by $50,000.
What are my options for my underwater mortgage besides walking away?
Before you walk away from a mortgage, make sure you’ve seriously considered the following possibilities:
Option 1: Stay in your home and keep making mortgage payments
Real estate trends ultimately determine whether keeping the home is your best financial move. Consider your attachment to the home, your income and where you think property values are going in your neighborhood. Depending on how far underwater you are, is there a chance you’ll be able to build equity in your home over time? Could you increase your income or trim expenses to pay down the mortgage faster? Are you comfortable with the idea of staying put and waiting to see if home values rebound?
“I’ve seen cases where there would be little chance that the homeowner could ever recover. I’ve seen scenarios where the market picked up and they would no longer be underwater,” says Allan Katz, a certified financial planner and president of Comprehensive Wealth Management Group in Staten Island, New York.
A relatively small uptick in home values can make a difference: If home prices were to increase by 5 percent, 216,000 homes would no longer be considered underwater, according to a recent CoreLogic equity report. On the flip side, there would be big trouble for homeowners: A 5 percent decrease in values would translate to 292,000 additional underwater mortgages.
Option 2: Seek a principal reduction
If your goal is to stay in your home, it’s worth asking your mortgage lender to consider a principal reduction. This is when a lender lowers the loan amount to provide relief for a distressed borrower, such as someone who is underwater due to market conditions. The lender might be willing to adjust your principal if it will help avoid the expense of foreclosure.
Principal reductions during the mortgage crisis were usually supported by programs like the Home Affordable Modification Program (HAMP) from the U.S. Department of Housing and Urban Development. Many federal programs have since expired, but you can still ask your lender to work with you to save your home.
Option 3: Request a loan modification
Another path to staying in your home is a loan modification, which changes the terms of your mortgage. Depending on your circumstances, a lender can lower your payment amount, lengthen the term of the mortgage or lower the interest rate.
The Fannie Mae Flex Modification program is another modification option. If you can demonstrate financial hardship, your lender could change your loan terms to a more reasonable level relative to the current value of the home.
“If that doesn’t work, [the borrower] can stop paying the mortgage, and after a while, the bank will threaten foreclosure,” explains Kevin O’Brien, a certified financial planner and founder and president of Peak Financial Services in Northborough, Massachusetts.
Option 4: Refinance your mortgage after building equity
Lenders usually don’t allow you to refinance a mortgage that is underwater — you need to have some home equity. Instead of walking away from the mortgage, your best bet is to make payments on the loan until you’re in positive territory before refinancing.
There are also two federal programs that help distressed homeowners refinance more easily: Fannie Mae’s High LTV Refinance Option and Freddie Mac’s Enhanced Relief Refinance. These are similar to the now-expired Home Affordable Refinance Program (HARP). You can contact Fannie Mae at 800-232-6643 or Freddie Mac at 800-373-3343 to see if you are or could become eligible.
Option 5: Sell your house through a short sale
Another way out of an underwater home is a short sale, in which you try to sell your home on the open market for whatever you can get, and ask your lender to forgive the amount of the mortgage beyond the sale price.
Lenders might approve a short sale to avoid the expense and hassle of a foreclosure, but they can also reject it. Also, don’t be fooled by the name: Short sales are complicated and can take a long time to complete. You’ll need an experienced agent to increase your chances of success of finding a buyer and getting bank approval.
Option 6: Use a deed-in-lieu of foreclosure
Your next best option might be a deed-in-lieu of foreclosure. This is when you reach an agreement to sign the deed to your home over to the lender, often in exchange for getting out of the mortgage with no further obligations. The advantage over simply walking away is that a deed-in-lieu is often a shorter process than foreclosure. Also, it might hurt your credit score a little less.
What does walking away from a mortgage mean?
When you can’t find a better option for your underwater mortgage, strategic default might be the only sound choice. After determining that your home has become a bad financial investment, you might decide to simply stop making mortgage payments — “walk away” — and default. Eventually, the lender will foreclose on your home. So, while you’ll walk away from your mortgage payments and the debt, you’ll have to walk away from the property, too, and think about where you can live next.
During the mortgage crisis, strategic default — also called “strategic foreclosure” — came to mean that the homeowner chose this path regardless of whether he or she could afford the payments, knowing that foreclosure would be the result. Underwater mortgages peaked at 26 percent of all mortgaged homes in 2009. The ensuing surge in property values has helped many mortgages climb above water, with just 2.8 percent of all mortgaged properties (1.5 million homes) underwater as of the end of 2020, according to CoreLogic.
What are the downsides of strategic default on a mortgage?
Like a conventional foreclosure, walking away from an underwater mortgage affects your financial life and credit score for many years. Be aware of some of these potential consequences of walking away from an upside-down home:
Debt after foreclosure
Your lender might come after you for money owed after a foreclosure sale. Depending on the laws in your state, a lender might be able to pursue the remaining debt from an unpaid loan by obtaining a deficiency judgment against you, or work with a collection agency to recoup losses.
For example, if you walk away from an underwater home with $100,000 remaining on the mortgage, and the bank receives only $80,000 from the foreclosure sale, it might try to collect the remaining $20,000. Some states permit creditors to garnish wages or take other steps to collect on the debt.
Non-recourse laws, however, protect homeowners in some states. When a borrower defaults in one of these states, the lender can take the home through a foreclosure but has no right to any other borrower assets. (Home equity loans are not eligible for this protection unless they were used as part of the home purchase.)
Before you walk away from your mortgage, consult a real estate attorney about the foreclosure laws in your state.
Damage to your credit score
A foreclosure, regardless of whether it’s due to strategic default or other circumstances, has a negative impact on credit. Foreclosures remain on a credit report for seven years, with the impact gradually lessening over time. With the hit to your credit, you’ll have a harder time getting credit cards or car loans, and pay higher interest and more fees. You can rebuild your credit by working to establish a history of on-time bill payments, but doing so can take years.
Difficulty getting a new mortgage
A voluntary foreclosure can impact your ability to qualify for a new mortgage for years to come. If you didn’t pay your first loan back, there is plenty of reason for a new lender’s risk department to be skeptical of your ability to pay back a new one.
After foreclosure, Fannie Mae generally requires a waiting period of seven years before you’re eligible for another conventional mortgage. There are exceptions in special circumstances, however. The waiting period can be shortened to three years if you’re able to document extenuating circumstances that are not likely to recur, like a sudden job loss or large medical expenses.
During that waiting period, you should take steps to improve your chances of getting approved for a new mortgage, including making on-time payments with all your other bills, securing a job with a steady paycheck and saving as much money as possible to help afford a large down payment.
Potential IRS tax bill
Tax liability is another potential danger of strategic default on a mortgage. After the bank forecloses and sells the house, it might forgive the remaining mortgage amount so you don’t have to pay it back. Still, you’re not entirely off the hook.
“This may trigger a 1099 form for the forgiven amount, though the income will be much lower than the balance of the loan,” O’Brien says. “Consult a tax advisor before doing this.”