What is an underwater mortgage?
Many people view their houses as more than just homes — they’re investment vehicles. It’s true that buying a house can protect against inflation and provide long-term financial benefits. But home purchases don’t always turn out that way. Sometimes real estate doesn’t appreciate in value or borrowers fail to build equity in the property at a decent rate.
The risk of your house falling underwater is a major concern for homeowners, with the most dire consequences including — but not limited to — taking a loss on your investment or even defaulting on your home loan. Given those high stakes, it goes without saying that you should avoid an upside-down mortgage at all costs.
What does it mean exactly to own an underwater house, though? And what can you do if you find yourself with an underwater mortgage? Don’t worry, we have all the answers to you’re most pressing questions about underwater homes.
What does it mean to be underwater on your mortgage?
Even if you don’t know exactly what it means when your house is underwater, you’re probably already aware of its negative connotation. You might even be under the impression that being underwater on your home loan is just about the worst position you can be in as a homeowner. Honestly, you wouldn’t be too far off the mark.
Define underwater mortgage
An underwater mortgage is a home loan that’s worth more than the house itself. In other words, you owe more on your mortgage than the current market value of your home. If you sold your house under these conditions, you wouldn’t make enough from the transaction to repay your lender.
It’s important to note that being underwater on your mortgage is based on the fair market value of the property — not how much equity you have put into your home. If your total loan amount is higher than the market value of your home, then you’re considered an underwater homeowner. That’s true even if you’ve paid down the bulk of your mortgage and owe less than the property’s current value.
Underwater loans are also frequently referred to as “upside-down mortgages” due to the reversal of loan amount and home value. “Negative equity” is another common term for this scenario because you owe more than the property is worth.
We won’t sugarcoat it — this is a bad situation to be in as a homeowner, although not an entirely unusual one. According to a 2020 ATTOM Data Solutions study, 6.6% of all mortgages in the United States fit the definition of an underwater house. Now, that might not sound like a very large number, but it actually represents roughly 3.6 million home loans. So, if you’re upside-down in your mortgage, then you’ve got company — not good company, mind you, but company all the same.
Lenders do have safeguards in place to prevent such a scenario from occurring: appraisals. Before signing off on a home loan, a lender will schedule a home appraisal to determine the market value of the property. This way, they can check that the house itself will provide enough collateral for the loan.
It’s not a foolproof system by any means, though. Professional appraisers can’t predict the future, and they don’t offer opinions on how market values could change in the near future. All they can do is to tell you what the home is worth at that particular time.
How does a mortgage go underwater?
It’s easy — and perhaps comforting — to assume that underwater homeowners only have themselves to blame for their precarious position. Surely they fell behind on their mortgage payments and failed to steadily pay down the principal balance on their home loans. While that may be the case in some situations, it’s possible to do everything right as a borrower and still wind up with an underwater house.
Arguably the most likely way for your home loan to go underwater has nothing to do at all with staying current on your mortgage payments. If property values in your local housing market completely tank, you could have underwater real estate on your hands, no matter how diligent you’ve been about paying your mortgage.
Imagine you bought a $500,000 home using a $450,000 loan. Several years later, the local housing market takes a big dip, and the fair market value of your property drops to $400,000. Now your home is underwater because the total amount of your mortgage is more than what the house is actually worth. And it happened entirely outside of your control.
If that sounds unlikely to happen given the current trajectory of the U.S. housing market, consider the aftermath of the 2008 housing crisis as a cautionary tale. Housing prices plummeted in the wake of that crisis, leaving millions of homeowners sitting on top of underwater houses.
With all that being said, some mortgages do fall underwater because of missed payments. Continually accruing interest will only put borrowers in a bigger hole to dig out of, so it’s important to stay on top of your mortgage payments.
What happens when you owe more than your house is worth?
On a day-to-day basis, you might not even notice that anything’s changed with an underwater loan. You’ll continue making payments as scheduled and you’ll steadily chip away at the principal left on your mortgage. But problems may arise with an underwater mortgage under certain conditions.
When does an underwater mortgage cause problems?
- Taking out a home equity loan
- Refinancing your mortgage
- Selling your home
- Falling behind on your mortgage payments
Taking out a home equity loan
Many homeowners use home equity loans to cover expenses that they otherwise might not be able to afford. Both home equity loans and home equity line of credit (HELOC) mortgages enable borrowers to pay for everything from renovations to medical bills. You can even use these types of loans to consolidate high-interest debt.
As their names suggest, both home equity loans and HELOCs trade off of equity. The total amount a lender will provide on a home equity loan is directly tied to your property’s market value. If you have an underwater house, then there may not be a lot of equity for you to tap into on a HELOC. A lender may even reject your application altogether under these circumstances.
Refinancing your mortgage
Shrewd homeowners know that you should capitalize on favorable mortgage lending conditions when they arise. If interest rates are down, then refinancing your mortgage could be a very smart financial move. You’ll pay less interest on your mortgage, reducing your monthly payments as well as the total cost of your home loan.
But refinancing a home that’s underwater can be very difficult, if not impossible. Remember, an underwater loan is also known as negative equity. Not only do you lack any equity in your home, but actually owe more than it’s worth. Lenders will be extremely hesitant to refinance an underwater mortgage, so you may be stuck with your existing loan terms unless you’re able to turn your home loan right side up again.
Selling your home
In many cases you can sell your home with an upside-down mortgage, but it’ll cost you. When you sell real estate, the proceeds from the transaction will pay off your remaining loan balance, and whatever’s left over will go to you as profit — minus some closing costs, of course.
Since the market value of your underwater house would be lower than your original home loan, any offer you receive will likely undercut your existing mortgage. That means the proceeds from the home sale would not cover your loan amount. So, who’s responsible for repaying the lender for the rest of your mortgage? You, and out of pocket, to boot.
Taking a loss may not be financially feasible for homeowners. You expect to make money when selling real estate, after all, and you may not have funds on hand to repay the full remainder of your mortgage after the sale is completed. It should come as no surprise then that many underwater homeowners choose to wait out the market rather than sell and lose money on the investment.
Falling behind on your mortgage payments
The three scenarios described above are pretty far from ideal, but at least they don’t threaten your living situation. That’s not the case if your underwater loan is the result of missed payments. Eventually, you may default on your home loan and that will put you at risk of foreclosure.
The worst-case scenario with an upside-down mortgage is that the bank forecloses on your house. Always pay your mortgage on time each month to head off this potential risk.
3 tips to avoid an underwater mortgage
Getting out of an underwater home loan can be very difficult, especially when the situation has been created by housing market conditions. When it comes to these scenarios, the best offense is a good defense — that is, you want to avoid them altogether. Follow these three tips to avoid an upside-down mortgage:
3 ways to prevent an upside-down mortgage
- Stay away from risky housing markets
- Keep up with your mortgage payments
- Invest in your home
1. Stay away from risky housing markets
Consumer demand has remained relatively strong since the COVID-19 pandemic first began. Combine that with consistently low inventory, and you have all the makings of a competitive and healthy housing market.
But not all regional housing markets in the U.S. have fared so well. And even demand in red-hot markets may taper off eventually. With so much uncertainty about what the future holds, you need to be judicious about which areas you buy into to avoid investing in property that may lose value in the years to come.
2. Keep up with your mortgage payments
Probably the best step you can take as a homeowner to prevent an underwater mortgage is to simply stay on top of your housing costs. As long as you’re continually building equity in your home, you can minimize the risk of an upside-down loan.
You may still be at the whims of the housing market, but you won’t have to worry about accruing excessive interest on missed payments. More importantly, you can set aside any concerns about defaulting on your mortgage and running the risk of a foreclosure.
3. Invest in your home
There may not be much you can do about broad housing market trends, but you can improve your home’s value in other ways. Investing in home improvement projects like kitchen renovations, bathroom expansions and home additions can increase your property value. Adding in-demand features and amenities can make your home more appealing in any market, boosting its value even if surrounding properties aren’t doing so well.
How can you get out of your underwater mortgage?
Don’t lose hope if your home loan is underwater. Even if the situation seems dire, you have upside-down mortgage options to consider:
- Reach out to your lender: Your lender may work with you to adjust your loan terms through select financial assistance programs. Note: This is not the same as refinancing your mortgage.
- Wait out the market: A downturn in the housing market may be temporary, so your best course of action may be to simply continue making mortgage payments and wait for conditions to improve.
- Sell your house (at a loss): Admittedly, this is not the best course of action to take, but if you absolutely need to get out of your home, you could sell it and take a loss. That assumes you have funds on hand to pay the difference to your lender, though.
- Consider a short sale: If all else fails, your lender may agree to you selling your home as a short sale. You’ll need to meet certain requirements to qualify for a short sale, and even if it goes through, you’ll almost certainly lose a good amount of money in the transaction. In a worst-case scenario, though, that could be preferable to the financial ramifications of carrying a loan you can’t afford and eventually going through an underwater mortgage foreclosure.
Can you refinance if your house is underwater?
As we discussed earlier, lenders will almost never sign off on a refinance if you have an upside-down mortgage. Notice that we said, “almost,” though. There are some refinance options for upside down mortgages, but they could be more accurately described as financial relief programs.
- Freddie Mac Enhanced Relief Refinance
- Fannie Mae High LTV Refinance
Freddie Mac Enhanced Relief Refinance
If you have a Freddie Mac home loan and have stayed current on your mortgage payments for at least 12 months, you could qualify for the government-sponsored enterprise’s refinance program. You’ll pay off your unpaid principal balance, interest and certain closing costs. Think of it as a fresh start on your home loan.
Fannie Mae High LTV Refinance
Like Freddie Mac, Fannie Mae has a program in place to help homeowners refinance underwater homes: the Fannie Mae LTV Refinance Option. The LTV in this case stands for loan-to-value ratio, which measures the size of your mortgage against your property’s market value.
You’ll need to meet certain eligibility requirements to qualify for relief — most notably, your home loan needs to be owned by Fannie Mae. But you’ll find a ton of perks to this underwater refinance program: lower monthly payments, reduced interest rates and a shortened amortization schedule, to name just a few.
You may have heard about the Home Affordable Refinance Program (HARP) as a potential option, as well. However, HARP was a short-term program created in the aftermath of the 2008 housing crisis and expired in 2018. As of 2021, there are no plans to revive HARP or launch similar underwater refinance programs.
Being underwater on your mortgage means that your loan amount is higher than the actual value of the property itself. This can happen when housing markets crash or when property values simply drop in a particular area. It can be difficult to sell an underwater house — well, without taking a loss on the transaction, that is. And in most cases, you won’t be able to refinance an upside-down mortgage.
You may think you can’t find any help for underwater mortgages, but there are actually a couple of relief programs to explore. Your home loan will need to be owned by either Freddie Mac or Fannie Mae to qualify for those refi options, though.
If you suspect that your home is underwater, your first step should be to reach out to a qualified mortgage expert who can review your situation. They may be able to point you toward relief options you hadn’t considered or even rework the terms of your loan to mitigate the effects of an upside-down loan. But you’ll never know what options are available until you contact your lender and find out for yourself.
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