What is an Underwater Mortgage? A Complete Guide

An underwater mortgage, also known as negative equity or an upside-down mortgage, refers to a situation where the mortgage loan balance is higher than the current market value of the home. This typically occurs when home values decline significantly after the homebuyer purchases the property. Underwater mortgages can present challenges for homeowners, but there are ways to manage the situation.

How Does a Mortgage Become Underwater?

There are a few key reasons why a mortgage may end up underwater

• Declining home values – If home prices fall in the local market after the purchase the home’s value could drop below the outstanding mortgage balance. This occurred frequently during the 2008 housing crisis when home values plummeted nationally.

• Taking out a large loan – If the original mortgage was close to 100% of the home’s purchase price, even a small decline in home values could leave the loan underwater Putting less than 20% down increases this risk

• Paying mostly interest early on – In the early years of a mortgage, monthly payments primarily go toward interest. Less money builds equity in the initial years, increasing underwater risk if values fall.

• Missing payments – Missed payments can add up with late fees, leaving the balance higher than the depreciating home value.

Signs Your Mortgage is Underwater

There are a few key ways to identify if your mortgage is underwater:

• Compare your balance and home value – Compare your current mortgage balance to estimated home values in your area. Online valuation tools like Zillow provide home value estimates.

• Review your annual mortgage statement – Your lender provides an annual statement showing your current mortgage balance. Compare this to your home’s estimated worth.

• Check your loan-to-value ratio – Calculate your LTV by dividing your balance by your home value. A ratio above 100% means you likely have negative equity.

• Get a professional appraisal – For the most accurate assessment, hire an appraiser to evaluate your home’s current market value.

Risks of an Underwater Mortgage

Being underwater on a mortgage carries some financial risks and complications:

• Difficulty refinancing – Most lenders require at least 20% equity to refinance. Negative equity makes it harder to get approved.

• Challenging to sell – Selling requires paying off the entire loan balance. With negative equity, the sale proceeds may not cover the existing mortgage.

• Higher foreclosure risk – Underwater borrowers who experience financial hardship may be more likely to face foreclosure if unable to make payments.

• No equity to leverage – Tapping home equity through lines of credit or cash-out refinancing is restricted when no equity exists.

Options for Managing an Underwater Mortgage

If you find yourself underwater, here are some potential options to consider:

• Continue making payments – Keep paying your mortgage if you can afford it and wait for equity to build. Home values may rise over time.

• Refinance with government programs – An FHA Streamline Refinance or HARP may be available even with negative equity if eligibility requirements are met.

• Loan modification – Lenders may approve balance reductions, interest rate decreases, or extended terms to lower payments on underwater mortgages. Ask your lender.

• Forbearance or hardship programs – Temporary payment reduction or suspension programs can provide relief for underwater borrowers facing financial hardship.

• Short sale – Sell the home for less than you owe with lender approval. This avoids foreclosure but will damage your credit.

• Deed-in-lieu of foreclosure – Voluntarily transfer ownership to the lender instead of going through foreclosure. Hurts credit but not as much as foreclosure.

• Bankruptcy – Filing for bankruptcy stops foreclosure and may eliminate mortgage debt entirely through bankruptcy discharge.

The Bottom Line

An underwater mortgage can create a stressful situation, but does not automatically lead to foreclosure. Being proactive, assessing your options, and seeking lender assistance can help underwater homeowners handle the situation effectively. With strategic planning, you can protect your credit and financial future even with negative equity.