U.S. home prices rarely fall during recessions, and the latest downturn follows that pattern.
What is underwater?
In real estate, underwater is a term used to describe a buyer who owes more on the property than the property is worth.
Usually, a combination of factors causes a homeowner to owe more than the home is worth.
Owner bought at the height of a housing bubble: Real estate values fluctuate. When buyer demand is high and inventory is low, this causes a housing bubble. At the height of a housing bubble, properties are at their highest prices. Eventually, the bubble bursts, causing property values to fall and property availability to increase.
It is easy for homebuyers who purchase at the height of a bubble to become underwater on their homes. For example, if a homeowner owns a home valued at $350,000 and has a $340,000 mortgage, he has only $10,000 worth of equity. If the housing bubble bursts, a decline of 5 percent in property values will wipe out the equity and put the homeowner underwater.
Small down payments: There is a plethora of mortgage products that permit people to buy homes with down payments that are significantly less than the conventional 20 percent down. Both VA loans and USDA loans permit buyers to purchase homes with a 0 percent down payment, while FHA loans allow down payments as small as 3.5 percent. These loans increase the likelihood that a homeowner will become underwater on a home.
For example, if a buyer makes a 20 percent down payment on a $150,000 home, this gives the buyer approximately $30,000 in equity in the home. This gives the buyer a bit of leeway if a market correction in prices occurs. Buyers with no down payment easily have homes that are underwater if property values experience even a small decline.
Excessive borrowing against the home: Though new homebuyers have a propensity to become underwater on their homes, long-term homeowners are not immune. Once a homeowner establishes equity in the home, it is possible to take out a home equity loan or line of credit. For example, if a homeowner owes only $100,000 on a home that is worth $200,000, there is $100,000 worth of equity for the homeowner to borrow against.
Exactly how much of the equity the homeowner can borrow varies based on the lender. If a lender permits homeowners to borrower up to 85 percent equity in the home, this cuts the equity from the previous example to $15,000. A swing in the real estate market easily dissipates this equity, causing the homeowner to be underwater on the home.
Example of underwater
If a homeowner owes a $200,000 mortgage on a house with a value of $150,000, the homeowner is underwater.
Though it sounds scary to owe more on your property than it is worth, if you plan to stay in the property for an extended period, there is no reason to panic. Changes in home values in your area may cause the value of your home to rise. As you make regular mortgage payments, you’ll pay down your loan balance and help lift your property out of water.
If you need to sell a home that is underwater, one option is to inquire whether the bank holding the mortgage will permit a short sale. Short sales occur when the bank agrees to take less money than the balance on the property. This option adversely affects your credit, but the effects are not as severe as a foreclosure.
Use our calculator to figure out how much house you can afford.