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Buying a home is a generally sound investment, one that lets you build generational wealth by amassing equity over time. However, if you buy when prices are high and home values retreat, your home can lose value. You could wind up with a mortgage balance that outstrips your home’s market value.
“Being underwater or upside down on a home, car or any other asset means that you owe more than the current value and have negative equity,” says Greg McBride, chief financial analyst at Bankrate.
Being upside-down is much less common now than it was in the Great Recession. During the 2008 housing crisis, many borrowers were saddled with homes valued at far less than they paid. Housing markets can be unpredictable, and home values can fall as a result of rising interest rates, high rates of foreclosures or natural disasters. Underwater mortgages usually occur during an economic downturn in which home values fall, says Jackie Boies, a senior director of housing and bankruptcy services for Money Management International, a Sugar Land, Texas-based nonprofit debt counseling organization.
How does an underwater mortgage happen?
Say Jane bought her home for $300,000, made a $30,000 down payment and borrowed $270,000. Two years later, Jane becomes unemployed, but has an excellent job opportunity in another state. She needs to sell her house and move, but she learns that home values in her area have declined and her house is valued at $250,000 — and, she still owes $258,400 on her mortgage. She is now underwater, or upside-down.
In addition to declining home prices, homeowners can find themselves in this financial situation when they buy homes with little or no money down or borrow against most or all of the equity, McBride says.
“Note that even a stagnant home price can leave you upside-down if you wish to sell the home soon after because the transaction costs of selling could more than offset what little equity you have,” he says.
Another way to become upside-down would be borrowing secondary financing equaling more than 100 percent of the value of the home, or taking out a mortgage that would result in negative amortization over the life of the loan, adds Holly Lott, a senior branch manager at Atlanta-based Silverton Mortgage.
Why an underwater mortgage can be risky
Most consumers can keep making their payments and “over time can get right-side up by paying down some of the principal balance and/or seeing some appreciation in the price of the home,” says McBride.
Still, there are some times when a homeowner should be concerned about being upside down on their mortgage.
- Refinancing: People who find themselves in hardship may find it nearly impossible to refinance, unless they qualify for a government program or certain types of mortgages, says Bruce McClary, spokesperson for the National Foundation for Credit Counseling, a Washington, D.C.-based nonprofit organization.
- Selling: If you’re underwater, you will also have a hard time selling. If a homeowner can’t make enough from their sale to cover their mortgage balance, they will be responsible for making up the difference. Or, you will need to apply for a short sale with your lender, which is a type of sale where the bank agrees to accept less than the total remaining mortgage balance. This harms your credit score.
- Possible foreclosure: If a home doesn’t sell as a short sale, the next step is foreclosure. When a home is underwater, you are at a higher risk of foreclosure if the payments become too much for you.
What to do if you’re underwater on your mortgage
1. Stay in the home and build equity
Homeowners who find themselves underwater on their mortgage have several options. One is to stay in the home and continue to make payments to reduce the principal balance on the mortgage.
“Essentially, you’re riding out the market until values take a turn and go higher,” Lott says. “During this time it would be beneficial to make extra payments on the principal balance of the loan while waiting for home values to rise.”
2. Explore refinance options
You have fewer refinancing options available to you if you’re underwater, but you’re not totally out of luck. It is possible to refinance an underwater mortgage. Available programs include Fannie Mae High Loan-to-Value refinancing loans. These loans are paused as of December 2022, but the program could reopen in the future.
You might also qualify for a streamlined Federal Housing Administration loan if your original loan was FHA. Unfortunately, Home Affordability Refinancing Program (HARP) loans ended in 2018.
3. Consider a short sale
Homeowners could also consider a short saleavoid foreclosure and move to a more affordable housing situation, McClary says.
In a short sale, the lender must agree to accept less than the amount owed on the mortgage, making it a loss for them, Lott says. Lenders will only consider a short sale as a final option before foreclosure, and overall, it isn’t “great for the homeowner as the short sale will be reported on their credit report and they will face time frame requirements before being able to purchase a home again,” she says.
4. Walk away from your mortgage
Another option is to simply to walk away from the mortgage — a move called a “strategic default” — but, like a short sale or foreclosure, doing so can be damaging to your future homeownership prospects and credit score. In short, this option also puts you in a precarious financial situation. If you walk away, your lender could even hold you liable for repaying the debt.
Homeowners should obtain advice from a HUD-approved nonprofit housing counseling agency in these situations to “help identify solutions specific to your circumstances and community,” McClary says. There may be a way to resolve your situation besides walking away, which is really a last resort.
5. Foreclose and file for bankruptcy
Finally, you could allow your home to fall into foreclosure. During this process, the bank regains the home and the homeowner walks away with their debt wiped clean, but a credit score that is worse for the wear. Many people in foreclosure also file for bankruptcy to eliminate other debts.
There are long-lasting repercussions for these options, Lott says. A bankruptcy and foreclosure can stay on your credit report for 10 years, and, like the other options, limit your ability to buy another home for several years.
Signs that your mortgage is underwater
Finding out if you are underwater requires an assessment of your home’s current value. You can use a home value estimator tool to get a ballpark idea. However, to know for certain, you will need to get a home appraisal done by a professional. An appraisal considers your home’s condition and amenities, plus the value of homes like yours that have recently sold nearby.
When the real estate market takes a dive, many homeowners wind up with a home that depreciates faster than their mortgage balance declines. If you wind up underwater, it’s harder to sell and refinance. Consider looking into refinancing options for people in your situation or waiting out the market. If you need to move, renting your property could be a good alternative to selling until the value improves.