Mortgage Options for Underwater Homeowners

What Is an Underwater Mortgage?

An underwater mortgage occurs when the outstanding balance on a mortgage loan exceeds the value of the home or property. An underwater mortgage can happen when the home’s value decreases below the loan amount owed on the property.

Also called an “upside-down” loan, an underwater mortgage can occur for several reasons, including:

• A decline in real estate prices
• A deteriorating neighborhood
• Borrowing more than one can afford
• Taking out an exotic mortgage, such as an option adjustable rate mortgage, whereby the initial payments don’t cover the monthly interest or principal
• Withdrawing too much home equity through refinancing, which can increase the homeowner’s debt

Navigating an underwater mortgage can be challenging and may involve selling the home for less than the loan amount—but there are solutions. Discover the options available for homeowners with an underwater mortgage.

Key Takeaways

• An underwater mortgage is a mortgage loan with a higher loan amount than the value of the home, creating negative equity.
• An underwater mortgage can occur due to declining real estate prices or when the borrower uses refinancing to take out equity.
• A short sale may help those with an underwater mortgage if the difference between the home’s selling price and the mortgage is small.
• A foreclosure is an option when the homeowner ends up owing money to the bank after the home sale.

Short Selling a Home That’s Short on Equity

A homeowner with an underwater mortgage owes more on the balance of their mortgage than the home is worth—also called negative equity. Financially distressed homeowners may initiate a short sale because they can no longer afford to make the payments.

Short Sale Explained

A short sale is when a property is sold for less than the outstanding mortgage loan amount. The mortgage lender must sell the home to another buyer and apply the proceeds from the short sale to the outstanding loan of the original borrower.

The mortgage lender can forgive the remaining balance owed or pursue legal action to require the borrower to repay the remainder of the loan. If the homeowner can afford to repay the difference between the home’s selling price and the outstanding loan, they can bring a check to the closing.

Short selling can be an option if the difference between the home’s sale price and the amount mortgaged is small or the seller has deep pockets.

Lengthy Process

Convincing the bank or lender to agree to a short sale and finding a real estate agent willing to handle the sale can involve substantial time and paperwork.

If a buyer is found, the complications continue. The mortgage lender often services the loan on behalf of an investor. If the lender is comfortable with the sale, the lender must work with the investor holding the loan to reach an agreement.

If the house is covered by private mortgage insurance (PMI), the insurer might also be involved in the process. The mortgage insurance company has insured the property against default of the loan to protect the bank’s interests, so the insurer has a stake in the process. Generally, the time frame to reach an agreement is long, and the bank has little incentive to cooperate.

Foreclosure

If a homeowner cannot repay the outstanding mortgage loan to the bank, the mortgage lender may begin the foreclosure process even after a short sale. A foreclosure is when the lender takes ownership of the home and resells it to recoup the amount on the defaulted loan. Lenders will typically work with the borrower to avoid foreclosure, but the legal process can vary by state.

It’s important to weigh this option very carefully since it can damage your credit score and prevent you from obtaining credit in the future—although a short sale also hurts your credit.

Challenges include setting up the sale, the possibility of owing money after the sale, and the likelihood of your credit score getting damaged. However, taxes must also be considered since the difference between the home’s selling price and the balance on the mortgage might be viewed as income.

Paying the tax or proving you were financially insolvent and thus exempt from the tax may be necessary since the Internal Revenue Service (IRS) can view a short sale can as debt forgiveness. Please consult a tax professional to fully understand your particular tax situation.

Rent Out or Remain in the Home

The ideal scenario is to continue living in the home and paying the mortgage until the real estate market improves and the house can be sold for a price that covers the balance on the mortgage.

Other options to consider include taking in a roommate to help pay the bills or renting out a portion of the home or the second floor. You can also move to an apartment and rent out the entire house.

Important

Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report, either to the Consumer Financial Protection Bureau or the U.S. Department of Housing and Urban Development (HUD).

What Is the Difference Between a Short Sale and a Foreclosure?

Both short sales and foreclosures can help homeowners with negative equity. However, a short sale is a voluntary action for the homeowner and requires approval from the lender. Conversely, foreclosures are involuntary, whereby the lender takes legal action to repossess the home and sell the property.

How Do Short Sales and Foreclosures Affect Credit Ratings?

Both foreclosures and short sales can negatively impact your credit score. However, foreclosures have a much more negative impact and generally stay on credit reports for seven years.

How Many Underwater Mortgages Are There in the U.S.?

According to a study provided by CoreLogic, as of the fourth quarter of 2023, one million homes had underwater mortgages, equaling 1.8% of all mortgaged properties.

The Bottom Line

An underwater mortgage occurs when your mortgage loan is higher than the value of the home. An underwater mortgage can happen when housing prices decline, or a homeowner borrows too much of the home’s equity.

Borrowers can initiate a short sale, which involves selling the property for less than the loan amount and asking the lender to forgive the difference or arrange to repay that amount later. A foreclosure is the worst outcome since it involves the lender taking possession of the home to sell the property and recoup the loan amount. If you find yourself falling behind in your payments, contact your mortgage lender right away and ask for assistance.

Read the original article on Investopedia.