If you've ever heard the term underwater in reference to a mortgage, you might wonder how it happens. How could you owe more on a home than it's worth?
That's essentially what the term refers to. Your home loan has a higher principal than the home's value; therefore, you're underwater, or more specifically, your mortgage is.
Other loans aside from mortgage loans can also end up underwater, including car loans.
There are two main ways that a mortgage can become underwater. The first is if there's a decrease in the value of your property, and the second is if you miss payments on your home loan.
If you want to buy a house for $400,000, the bank will have an appraisal done and make sure that the home is worth that amount. Then, you put down your down payment.
A few years later, the average property values in your neighborhood or area might be on the decline, and then if anyone is selling, they might have to lower their prices because the demand is lagging. The property value decrease means, let's say, that your home is only worth $300,000, but you still owe more than that on your mortgage.
In the second scenario, you get underwater because you miss mortgage payments.
When you're initially making payments on a loan, most of the money goes towards paying the interest. Eventually, you can begin chipping away at the balance of the principal, and you're paying less in interest. The whole process is known as amortization. It accumulates if you don't pay off your interest for one month. If you're facing compounding interest, paying your loan back is harder and can put you underwater.
If you're underwater, you don't have equity in your home or negative equity.
This can lead to serious consequences.
One is that if you're underwater, you lose your ability to refinance your loan. Almost any lender will want you to have some equity before you can refinance.
The second issue arises if you want to sell your home. Typically, you take the balance from the sale of a home and pay down your existing mortgage when you sell it. If you can't sell your house for enough to cover your outstanding principal, you either have to stay in the home or sell it and cover whatever else you owe from your savings. You could sell through a short sale.
The third problem with an underwater mortgage is that you may face foreclosure risk.
Foreclosure happens if you fall so far behind on your home that your lender seizes your property.
Depending on the circumstances, you might not even know that your mortgage is underwater.
One sign is falling local property values, which is currently happening in many markets around the country. If there's a big difference between the balance of your loan and the value of homes in your area, you might be underwater.
Another red flag of being underwater is a low appraisal or if you're behind on payments.
If you don't plan on selling your home or refinancing soon, you might wait until property values go back up.
If you don't have the option, there are choices for underwater homeowners. For example, you might qualify for the Freddie Mac Enhanced Relief RefinanceSM program, which replaces the HARP program that ended in 2018. It's a refinance option for homeowners not qualifying for standard refinance.
Finally, the other option was briefly mentioned above—a short sale, which can be an alternative to foreclosure if facing financial challenges. With a short sale, you sell your home for less than what's owed on the mortgage. Your mortgage lender would get all of the proceeds of the sale, and then they'd forgive the difference in what you owe or get a deficiency judgment. That would require the original borrower to pay what's owed.
