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.