How to refinance an underwater mortgage

If you owe more on your mortgage than your home is worth, you have what’s known as an underwater or upside-down mortgage. Mortgage loans can become underwater when property values fall.

This unhappy status was commonplace during the Great Recession of 2007-2009. That’s when home values nosedived and continued to fall long after the recession’s end. Many homeowners with purchase or refinance loans that originated in the early and mid-2000s ended up underwater in the wake of the housing crisis.

Being underwater is a scary state, making it challenging to sell your property and limiting other options, like borrowing against it. What if you try to refinance the mortgage for a fresh start? It won’t be easy, but you do have options. Let’s take a closer look at what underwater mortgages are, how to know if you have one, and options for refinancing underwater mortgages.

How to refinance an underwater mortgage

First thing you should know: refinancing an underwater mortgage can be tricky, because you don’t have any home equity. Banks generally require borrowers to have some skin in the game to get a home loan.

“Banks typically want to secure their interest with some amount of home equity, so it’s typically not possible to refi an underwater mortgage. However, renegotiating terms on the existing loan may be an option,” says Peter Palion, a certified financial planner in East Norwich, New York.

The first step when you have an underwater mortgage is to contact your lender to explore your options.

Step 1. Confirm your mortgage is underwater

Determining if your mortgage is underwater is simply a matter of identifying the amount you owe on your mortgage and comparing it to your property’s market value.

Determine how much you owe

Refer to your most recent mortgage statement to find your outstanding principal balance. If you need the most up-to-date information, call your loan servicer and ask for your loan payoff amount. The payoff amount includes the interest and fees that have accumulated since your last statement.

Know your home’s value

Once you know your mortgage payoff amount, you’ll want to determine the fair market value of your home. You can get a ballpark figure using real estate marketplace sites and comparing home values of similar homes sold in your neighborhood. However, getting an appraisal from a licensed home appraiser may deliver the most accurate estimation.

Calculate your equity

A little math can help you confirm if you have an underwater mortgage. Determine your equity by subtracting your home’s balance from its value. For example, if your home is worth $300,000 and you owe $325,000, then your equity is -$25,000 ($300,000-$325,000=-$25,000). In this example, your mortgage is $25,000 underwater. Or, to put it another way, you have $25,000 in negative equity.

Step 2. Contact your lender

Call your lender as soon as you know your mortgage is underwater. Don’t procrastinate, even if you feel overwhelmed or uncertain. It’s best to let your lender know the situation and try to work out a reasonable plan.

Step 3. Learn your options

Will anyone refinance an underwater mortgage? You may be surprised to know that some refinancing opportunities exist for qualified borrowers. Here are a few options to consider:

FHA Streamline Refinance

If you already have a Federal Housing Administration (FHA) loan, an FHA Streamline refinance may make sense. “Streamline” refers to the limited documentation and underwriting done by the lender. In fact, FHA Streamline refinances don’t require a home appraisal, making it easier for homeowners to refinance underwater mortgages.

Requirements include:

• You must have an FHA mortgage.
• The mortgage you wish to finance must be current.
• You can now take out more than $500 cash using the streamline refinance process.

USDA Streamline Assist Refinance

The United States Department of Agriculture (USDA) offers a Streamline Assist Refinance that may be a good option for refinancing when you’re underwater. If you’re a current USDA direct or guaranteed home loan borrower, you may qualify for a refinance loan with:

• Low or no equity
• No home appraisal or inspection (unless you’re a direct borrower who received a subsidy during your loan term)
• No credit review
• No debt-to-income ratio evaluations.

Not all mortgage lenders offer USDA loans, so be prepared to shop around to find a suitable lender with the best interest rates.

Requirements include:

• Must have a current USDA direct or guaranteed.
• Must be current on loan for 12 months prior before refinancing.
• Income must not exceed the adjusted annual income cap for your county or metropolitan statistical area.

How to qualify for underwater mortgage programs

While each program has its own unique requirements, there are some steps you can take to help increase your chances of qualifying for underwater mortgage programs. Perhaps most importantly, it’s important to remain current on your mortgage payments. Most programs require that you have no late payments in the past six months and only one late payment in the past 12 months. A track record of making on-time mortgage payments will make your application more appealing for underwater mortgage programs.

It’s also important to ensure that your loan is seasoned before applying. Having a seasoned loan means that a specified period of time has passed since you took the loan out. In some cases the seasoning requirement will be 15 months to qualify for an underwater mortgage program, while some programs may accept as little as 12 months.

If you can refinance, should you?

Advantages of refinancing an underwater mortgage

While refinancing an underwater mortgage can be challenging, there can be some benefits of doing so. They include:

• Quicker mortgage repayment: After refinancing, you may be able to direct the money you’re saving through reduced monthly payments toward paying down your mortgage balance more quickly.
• Get out from underwater: With more affordable payments, you may be able to reduce your mortgage balance enough over time that you’re no longer underwater and the loan balance is less than the value of the home.
• Reduced interest rate: If you’re able to qualify for a refinance program, you may also be able to secure a better interest rate as part of the process.

Disadvantages of refinancing an underwater mortgage

• It costs money: As with any home loan, there may be closing costs or other fees and expenses associated with the refinancing process. 
• You may not break even: If you leave the home shortly afterward, you lose the money spent refinancing. It’s important to consider how long you really plan to remain in a home, and to calculate the breakeven point, in order to make the closing costs of a refi worthwhile.

What to do if you can’t refinance

Short sale

You can attempt to sell your home on the market and persuade the lender to accept whatever price it fetches, even if it is less than the balance you owe on the mortgage. This is called a short sale, and cannot be done without lender approval.

Short sales can take many months and require lots of paperwork. But they may be suitable if the only other option is waiting for the bank to foreclose on your home.

Walk away

Some homeowners with underwater mortgages choose to “strategically default” and walk away from their unmanageable debt, forfeiting the home. This is far from ideal, but many homeowners did so during the Great Recession. Consider this option very carefully before proceeding.

Pay down your mortgage balance

If you’re looking to rise above water, paying down your mortgage may be the most straightforward route. Of course, allotting extra money to your mortgage may not be within the budget for many people. But, if you’re able to pay more towards your mortgage, you may be able to refinance when you owe less than your home is worth. Keep in mind, many lenders set minimum equity benchmarks for refinancing, often 20 percent.

Request a mortgage modification

One potential option for underwater mortgage relief is a loan modification through your lender. As its name suggests, this agreement modifies the terms of your home loan.

Make no mistake, a mortgage modification agreement is not a refinance, and your lender is under no obligation to grant you new terms. However, if your lender agrees to reduce your principal balance, it may be enough to get your loan above water, or closer to being right-side up.

Just sit tight

If you want to stay in your home long term and can still afford the mortgage payments, you can choose to keep calm and carry on, even though your mortgage is underwater. Over time, the property may regain some or all of its past value — especially if the decline in value is due to a downturn in the economy  or a correction of your overheated local real estate scene.

“But it could be permanent if there have been changes in your local government, property taxes, school district, nearby construction and any other factors that can impact the housing market,” says financial planner Niv Persaud, managing director of Transition Planning & Guidance in Atlanta.

Next steps for refinancing an underwater mortgage

If you’re considering refinancing an underwater mortgage, the first step is to determine what type of loan you have and whether it qualifies for any of the programs available for your situation.

If you’re not eligible for refinancing at the moment, you may need to consider other options including short sale, requesting a mortgage modification, or continuing to pay down the balance until you’re able to rise above water.

But before you do anything drastic, analyze the reasons for your home’s drop in market value. If it’s happening to homes all around you, the result of economic conditions, just waiting it out might be the best plan.

Additional reporting by Mia Taylor