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Some homeowners who are underwater — meaning they owe more on the mortgage than the home’s current value — turn to “strategic defaults” in which they simply walk away from the debt.But financial experts warn the cost of skipping out on mortgage debt can be high.
What is an underwater mortgage?
When the current value of the house 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.
Homeowners with little or negative home equity can find themselves in this situation when property values fall, even when they’ve made all payments on time. It’s also referred to as being “upside down” or having “negative equity” in the home.
How to tell if you’re underwater on your mortgage
There are three simple steps to determine whether you’re underwater on your home loan.
1. Find your mortgage balance
Check your mortgage account online or look at 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 value
Start gathering information on home value through online research. Type your address into a search box and compare home price estimates at real estate websites as a starting point. Then search for recent sales of similar homes near you and see how much they sold for. You may want to call a local real estate agent and ask for their opinion.
By this point, you might have a reasonably good idea of what your house is worth. If you’re still unsure, you can hire an appraiser to get a professional valuation.
3. Subtract your mortgage balance from your home value
For example, if you owe $150,000 on your mortgage, but your home is worth only $100,000 in today’s market, then you are underwater by $50,000.
If the amount you owe exceeds the estimated home value, you are upside down on your mortgage and should begin to carefully consider your options.
What are my options for my underwater mortgage besides walking away?
Strategic default — also called “strategic foreclosure” — on underwater homes became increasingly common during the financial crisis, when such mortgages peaked at 26 percent of all mortgaged homes in 2009. Many homeowners did the math and made a painful but rational decision to walk away from the upside down mortgage.
A decade later, 4.2 percent of mortgages are still under water, according to CoreLogic, affecting 2.2 million homeowners. Neighborhoods around Chicago, Miami and Washington, D.C., have the highest shares of homes with negative equity.
Before you walk away from home with negative equity, make sure you’ve seriously considered the following possibilities.
Stay in your negative equity home and keep making payments
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 that 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?
Real estate trends will ultimately determine whether keeping the house is your best financial move. “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 in Staten Island, New York.
Seek a principal reduction
If your goal is to stay, it’s worth asking your lender to consider a principal reduction. Lenders can lower the loan amount to provide relief for a distressed borrower, such as someone who is underwater due to market conditions. They might be willing to adjust your principal if it will help them to 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 expired, but you can still ask your lender to work with you to save your home.
Request a loan modification
Another path to staying in your home is a loan modification. Ask your lender if you’re eligible for a loan modification that changes the terms of your mortgage. Under some circumstances, mortgage companies can lower the payment amount, lengthen the term of the mortgage or lower the interest rate.
Fannie Mae has a program called Fannie Mae Flex Modification that you might qualify for. If you can demonstrate financial hardship, the lender could change your loan terms to a more reasonable level relative to the current value of the home.
“If that doesn’t work, they can stop paying the mortgage, and after a while the bank will threaten foreclosure,” says Kevin O’Brien, a certified financial planner in Northboro, Massachusetts.
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, so your best bet is to make payments on the loan until you’re in positive territory before refinancing.
There are 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). Call Fannie Mae at (800) 2FANNIE or Freddie Mac at (800) FREDDIE to see if you are or could become eligible.
Sell your house through a short sale
Another way out of an underwater home is a short sale. You can try to sell the house 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 may approve a short sale to avoid the expense and hassle of a foreclosure, but they can also reject it. Short sales are complicated and can take a long time to complete, so you’ll need an experienced agent to increase your chances of success of finding a buyer and getting bank approval.
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 of foreclosure is often a shorter process than foreclosure. Also, it may hurt your credit score less.
What does walking away from a mortgage mean?
When you can’t find a better option for your underwater mortgage, strategic default may be your only sound choice. After determining that your home has become a bad financial investment, you may decide to simply stop making mortgage payments. You’ll default and eventually the lender will foreclose on the home.
During the mortgage crisis, the term “strategic default” 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.
What are the downsides of strategic default on a mortgage?
Like a conventional foreclosure, strategic default affects your financial life and credit score for many years. Here are some of the 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 may pursue the remaining debt from an unpaid loan by obtaining a deficiency judgment against the delinquent borrower, or may 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 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 home, consult a local lawyer about the foreclosure laws in your state.
Damage to your credit score
A foreclosure — regardless of whether it is because of a strategic default or other circumstances — has a negative impact on a consumer’s credit score.
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 will 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
In addition, a voluntary foreclosure can impact a homeowner’s ability to qualify for a new mortgage for years to come.
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 able to document extenuating circumstances that are not likely to recur, like a sudden job loss or large medical expenses.
Having a large down payment can also help in getting a mortgage following a foreclosure.
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,” says O’Brien. “Consult a tax advisor before doing this.”