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When it comes to owning a home, some surprises aren’t as welcome as others. If you just found out that your outstanding mortgage balance is more than your home is worth, you have what’s known as an underwater mortgage, also known as an upside-down mortgage.
If you have an upside-down mortgage, don’t panic. You have several options to address the problem. This guide explains how a mortgage goes underwater, offers guidance on determining if you have an upside-down mortgage and discusses the options available to homeowners who want to build positive equity.
What Does Underwater Mortgage Mean?
Equity is the difference between your home’s value and the balance of your mortgage. You have positive equity when you owe less than the home is worth. If you owe more than the home is worth, that’s negative equity.
Let’s say you bought a $300,000 home when real estate prices were high. You put $40,000 down, and you’ve paid off $10,000 of your mortgage principal. That would leave you with a mortgage balance of $250,000.
But what if home prices suddenly drop? If the value of your home decreases to $240,000, you have $10,000 of negative equity in the property and an underwater mortgage.
When your mortgage is underwater, it’s more difficult to refinance the loan. And because you have negative equity, you also have fewer options for obtaining credit.
How Does a Mortgage Go Underwater?
A mortgage is more likely to go underwater if you make a small down payment rather than a large one. This is because a small down payment leaves you with less equity in the home when your mortgage closes.
For example, if you put 3.5% down on a $200,000 home, your down payment is $7,000. A major market change could easily cause your home’s value to decrease by more than $7,000, leaving you with an upside-down mortgage.
Your mortgage may end up underwater if the home is affected by a natural disaster. Damage caused by hurricanes, earthquakes, tornadoes and other natural disasters can reduce your home’s value, leaving you owing more on your mortgage than your home is worth.
Home values during a recession
Underwater mortgages are more common during a recession, which is a period of significant decline in economic activity across the economy for several months or longer. During a recession, the unemployment rate increases, leaving fewer people with the resources to purchase homes.
As a result, the housing market cools off, causing home prices to fall. If the economy enters a recession, reduced demand may cause the value of your home to drop below the balance of your mortgage.
How Do I Find Out if My Mortgage Is Underwater?
The first step is to determine the balance of your home loan. You can do this by reading your most recent mortgage statement. Look for a line labeled “principal balance.”
Next, you need to determine the value of your home. The most accurate way to do this is to hire a professional appraiser. You can also ask a real estate agent to provide you with a listing of home sales in your neighborhood.
For a budget-friendly option, the Federal Housing Finance Agency offers a free home value estimator. You can also use commercial pricing tools that allow you to enter your address and get a rough estimate. Just keep in mind that many commercial real estate websites may not have up-to-date information.
Finally, you’ll subtract your mortgage’s principal balance from the value of your home. If the result is a negative number, you have an upside-down mortgage. A difference of $0 or a positive number indicates that you’re not underwater.
Assume your principal balance is $282,000 and the value of your home is $272,000. To calculate how much you’ve got in equity, you’d subtract $282,000 from $272,000. The result will be $10,000 in negative equity, a sure sign that you have an upside-down mortgage.
Common signs of an underwater mortgage
Even if you don’t keep track of your principal balance every month, you should watch out for signs that your mortgage is underwater. One of the most common signs is property values decreasing in a neighborhood.
- Falling property values: Property values may decrease if your neighborhood has a lot of foreclosures. Foreclosures increase the supply of available homes, which may reduce home prices.
- Low appraisals: Low appraisals also affect housing prices, making underwater mortgages more common. Poor maintenance, overvalued home renovations and unusual market conditions can all lead to lower-than-expected appraisal values.
- Missed mortgage payments: You’re also more likely to have an underwater mortgage if you’ve missed some mortgage payments. When you miss payments, your principal balance doesn’t decrease as fast as it should. Therefore, you’re more likely to owe more than your home is worth.
It’s also important to understand your lender’s rules regarding grace periods. Depending on when you submit your payment, a late payment may fall within the grace period, shielding you from penalties.
What Are My Options if My Mortgage Is Underwater?
If your mortgage is underwater, you’ve got several options to tackle the problem. Having an upside-down mortgage isn’t the end of the world, so stay calm and see whether one of these options is right for you:
Stay in your home and hope the value rebounds
If you don’t have to move for work or family issues, one of the easiest things to do is to stay in your home and see if its value eventually increases. As market conditions change, the value of your home may increase, leaving you with positive equity.
Ask mortgage lenders to consider a principal reduction or loan modification
Modifying your loan can help with an underwater mortgage by making your monthly mortgage payment more manageable or by directly reducing your principal balance. If you decide to apply for a loan modification, make sure you understand the updated terms of the loan. You may have to pay a different amount each month or pay back the loan over a longer period of time.
Refinance your mortgage
Refinancing your mortgage pays off your existing home loan and replaces it with a new one. If you have an upside-down mortgage, it’s harder to refinance, but it’s not impossible if you have a government-backed loan.
Homeowners with Federal Housing Administration (FHA) loans, Department of Veterans Affairs (VA) loans and U.S. Department of Agriculture (USDA) loans may be able to use a streamline refinance. The advantage is that you may be able to refinance without getting an appraisal, making it possible to eliminate an underwater mortgage.
Sell your house through a short sale
In a short sale, you sell your home for less than the balance of your mortgage. You avoid foreclosure, but you still have to leave your home, so it’s not a decision to make lightly. If you decide to proceed with a short sale, make sure you understand all the details, such as whether you’ll be required to pay the difference between your mortgage balance and the value of your home.
Walk away and foreclose on the home
Because foreclosure seriously damages your credit history, it’s not something you should do without careful consideration and professional advice. But in some cases, walking away from a home is a financially sound option. The silver lining is that the damage to your credit history and credit score doesn’t have to last forever.
Bankruptcy is a legal process that gives you a fresh start after a period of financial difficulty. If you can’t make any of the other options work, consult a bankruptcy attorney to determine if this legal strategy can help you with your underwater home.
Sink or Swim Is Old Terminology – We Reach the Surface
If you have an underwater mortgage, don’t panic. Even if your home’s value doesn’t increase in the near future, you have several other options to bridge the gap between the current value of your home and the principal balance of your mortgage.
Because refinancing is a popular option, it’s important to make your mortgage payments on time and be vigilant with your personal finances. Using a little extra caution now may help you qualify for refinancing later.
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The Short Version
- Your mortgage is underwater if the principal balance of the loan exceeds your home's estimated value
- Underwater mortgages are more common during economic recessions
- Your options for dealing with an underwater mortgage include waiting for your home's value to increase, refinancing, a short sale, foreclosure or bankruptcy