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What Does It Mean To Be Underwater in a Mortgage?

What Does It Mean To Be Underwater in a Mortgage?

by Fred Fauth (email Fred) | | February 25, 2009 | 4 Comments »

With all the turmoil in the housing market these days, the term underwater is being tossed about quite frequently, especially as it applies to home and mortgages.  So what exactly does it mean to be underwater?

Being underwater in a mortgage means simply that the total debt secured by a property (e.g., the total value of all mortgage loans), exceeds the appraised value of that property.  Being underwater indicates a negative equity position. For instance, if you have a first mortgage for $100,000; and a second mortgage for $20,000, but your house appraises for only $110,000, you are underwater by $10,000.

Being underwater was very uncommon for the six years preceding the last 18 months because home prices were constantly on the rise, by as much as 20% year over year.  Of course, universal 20% growth is simply not sustainable, and the correction the markets brought in 2007 and 2008 has put many honest, hardworking payers in a negative equity situation.

Problems Caused by Being Underwater

The most significant problem caused by being underwater in a mortgage is the inability to move without putting up a large amount of cash to make up the deficit in value.  Since selling the property will not net enough proceeds to pay off the loan, homeowners are essentially stuck in their current residences unless they have a large financial reserve.   In forced-move situations (for instance, due to lack of employment in the area), homeowners must be foreclosed, or come up with a creative solution, like renting their current property and moving into a rental in the new location.

Worse yet for many homeowners is the inability to refinance the loan(s) to a lower rate.  As Ethan wrote about in his recent article, when a property is underwater, mortgage lenders don’t want to take the risk.  The fact that a homeowner already has a loan is of no consequence to a new lender (since refinancing would essentially shift the risk from the current lender to the new lender).

The Impact of Closing Costs

While the standard definition of being underwater is cited above, its important to consider the selling a property costs money (usually as much as 7-8% for realtor fees, transfer taxes, etc).  So, a mortgage of $100,000 on a $100,000 may still be considered underwater since the proceeds from the sale would only generate about $92,000, $8000 short of covering the entire loan.

Relief for Borrowers

In recent conversations with a mortgage lender for Wells Fargo, she said there’s been some rumbling in the community that a future housing bill passed by congress will attempt to ensure people with negative equity situations can still refinance to a lower rate.  How this will be achieved practically in the market remains to be seen, but we’ll write about it if we see things materialize.

What Should I do if I’m Underwater?

Basically the financial equivalent of holding your breath. Keep making payments on time for your loan.  This will preserve your credit report and score through the downturn.  Eventually, by sheer math, you’ll own more of the home.  If you have any difficulty keeping up your payments, contact your lender to determine options.  In dire situations, lenders can make loan modifications to either suspend principal payments, reduce interest rates, or re-amortize the loan to a longer payback period. Remember, lenders don’t want to foreclose on your property, especially in the current housing market.  They’ll be willing to work with you if you are serious about your commitment to them.

As a last resort, a short sale is an option for those who must move.  In a short sale, the bank authorizes you to sell your house for less than the total mortgage value and they agree to take a reduced payment for the loan.  There may be an impact to your credit score in this case, so it’s still a lose-lose, but it’s better than the alternative of full foreclosure.

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4 Responses to What Does It Mean To Be Underwater in a Mortgage?

  • Tom Thompsen responds...
    March 13th, 2009 1:56 am

    Dear Fred,
    If you are underwater in an original mortage, is it possible to sell then buy back your home and reset your basis to establish a loss that can be used as a tax deduction? I think all but transfer fees can be avoided in this kind of transaction.
    At a maximum of $3000.00 loss per year on federal taxes, it might take a fair amount of time (if ever) to recover the real loss, but it might be worth it for some people.

    [Reply]

  • Fred responds...
    March 13th, 2009 8:00 pm

    Tom,

    Interesting idea. Here’s some thoughts:

    First, if you are underwater in a mortgage, it means you don’t have enough to pay off the mortgage loan with the equity in the house. You must pay off the loan in order to sell the home (it would be illegal not to do this). When your proposed buyer tries to close on the home, the title company will find the lien on your home and will notify the lender you were trying to sell… Even if you conspired with the buyer to try to avoid the lien search (again, likely illegal in most places), all mortgages have a clause that if you sell or give away the property, the loan can be called immediately.

    But, I think the heart of your question isn’t really dealing with being underwater on a mortgage, but rather being in a loss position on the value of your home. Let’s just assume you bought a house for 500,000 cash, with no mortgage. Your home is now worth 300,000. Your question as I understand it: Can you sell and buy back the property, and claim the loss on your income taxes as a capital loss (which as you correctly noted, is limited to a 3000 deduction against ordinary income, but actually could be taken as a much larger deduction against capital gains, if you had them…)

    You’re Idea would be a good one if homes were considered “investments” by the IRS, but the reality is they aren’t. Homes are considered “personal property.” While you must declare a capital gain on a sale of personal property (and hence, why they can tax you when you sell the house and make over $500,000 on the sale), you cannot take a loss write down for personal property losses. So, if you sell and buy back your home, you’ll just put yourself into a lower cost basis, thus increasing your chances you would fall above the IRS’ allowed $500,000 exemption for MFJ returns.

    Hope that explanation is clear. Great Question!

    [Reply]

  • Help From Home Foreclosure is Finally Here responds...
    November 4th, 2009 6:20 am

    [...] to borrowers and loan servicers and investors to spur mortgage modifications, even if your home is underwater. The government will also subsidize interest rate reductions to get borrowers to affordable monthly [...]

  • Gary Drake responds...
    May 11th, 2010 1:04 am

    If you are underwater by more than $20,000. Walk away and rent. Don’t let guilt or morals get in the way. This is business. The banks aren’t thinking ethics when they foreclose on you if you don’t make payments.

    [Reply]





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