What is an Underwater Mortgage?

For many of us, our home is our biggest asset, but like other assets we invest in, such as stocks and bonds, property values fluctuate over time due to various factors. And when your home’s current value is less than what you currently owe on your mortgage, that means you are underwater on your mortgage.

Below break down what an underwater mortgage is, what can cause it, how to determine if your mortgage is underwater, and what options you have.

What is an Underwater Mortgage?

An underwater mortgage is when the loan's principal balance exceeds the value of the home it is financed for. It is also referred to as an upside-down mortgage or negative home equity, as the borrower owes the lender more than what their home is currently worth.

What can cause an underwater mortgage?

Underwater mortgages were prevalent during the Great Recession from 2007 to 2009, when U.S. property values saw a steep decline, and homeowners with mortgages based on pre-recession home values ended up with underwater mortgages.

Underwater mortgages are less common now because of stricter mortgage underwriting standards and record home price increases since the pandemic started in 2020. But they still exist today, and below are some examples of how this can happen.

Housing Market Decline

Let’s say you bought your home two ago for $200,000. You paid $40,000 for your down payment and financed the remaining $160,000. Your mortgage lender ordered an appraisal, and the home’s appraised value came back at  $200,000, so your $160,000 mortgage was approved.

Two years later, you notice that homes in your neighborhood are selling for less due to a decline in the housing market. These lower sale prices bring down the value of your home too. This is because your home's current appraised value would be based on recent sales of similar homes in your neighborhood. So let's say your home is now worth $120,000, but you still owe $155,000 on your mortgage issued two years prior. This would mean you currently have an underwater mortgage.

Missed Mortgage Payments

Your mortgage can also become underwater if you are behind on your monthly mortgage payments. When you start making payments towards your mortgage, most of it goes towards interest. Then, as your payments begin to chip away at the principal balance, you pay less in interest. This is called amortization. But if you miss mortgage payments, your interest will accumulate. This compounding interest makes it harder to pay the principal, which could also put you underwater on your mortgage.

How to Know if You Have an Underwater Mortgage

Comparing how much you owe on your mortgage against your home’s current value is the only way to determine if you are underwater. You can see how much you owe by checking your monthly mortgage statement or contacting your lender directly to determine your payoff amount, including interest and fees accrued since your last statement was issued.

To determine your property’s current value, a professional appraisal would give you the most accurate valuation and may be worth the cost if you plan to sell your home soon. You can get an approximate home value for free from a real estate portal like Zillow, Realtor.com, or Redfin.

Let's say your mortgage balance $225,000, but your home's value is $200,000. Then you have negative equity of $25,000, and your mortgage is underwater by that amount.

Challenges of Having an Underwater Mortgage

If you have an underwater mortgage but have no plans to sell or refinance and are current on your monthly payments, it should not pose any immediate problems. This is because your home's value could increase in the coming years, giving you positive equity and when you decide to sell or refinance, your mortgage may no longer be underwater.

Underwater mortgages typically cause problems for homeowners in the following scenarios:

• Trouble with Refinancing: To refinance your mortgage, lenders typically require borrowers to have at least 5% to 20% equity in their homes. But if you have an underwater mortgage, you have negative equity so may not be eligible to refinance.
• Unable to Sell: If you have an underwater mortgage, your home selling price may not cover your outstanding mortgage balance, so you would have to pay that balance back to your lender in cash at closing.
• Foreclosure: If your mortgage is underwater and you can no longer afford your loan payments, it increases your risk of foreclosure, especially as selling or refinancing may not be an option.
• Damage to Credit: If you have defaulted on your mortgage payments and the loan is underwater, your credit score can be negatively impacted, and that could prevent you from securing loans or credit in the future.

Options with an Underwater Mortgage

If you can afford your mortgage payments and do not need to sell or refinance, then you may not need to do anything. As time goes by and more payments are made to bring down your balance, coupled with the housing market's cyclical changes, it’s possible that your mortgage won’t stay underwater for the remainder of its term.

But if you are struggling with your underwater mortgage payments, taking action could help you from losing your home. Depending on your situation,  one of the options below may be your best solution.

Refinance Your Mortgage

If you can refinance your current mortgage with a new loan that has a lower interest rate and/or longer term, that can lower your monthly mortgage payments and help you avoid foreclosure while you wait for your home’s value to increase over time.

However, refinancing with an underwater mortgage is difficult because you have negative equity in your home. So you would need to pay your lender the difference of what is owed on your prior mortgage at the closing of your new loan. If you cannot make that lump sum cash payment, then refinancing may not be an option.

Loan Modification

A loan modification is when a lender changes the existing terms of a mortgage due to the borrower’s long-term inability to repay the loan. The goal of a loan modification is to reduce the borrower’s monthly payment, which can be done by reducing the principal amount, lowering the interest rate, changing from an adjustable rate to a fixed-rate loan, or extending the loan’s term.

A lender may agree to a loan modification if your mortgage is underwater, as it is a less costly and time-consuming alternative than initiating foreclosure or agreeing to a short sale.

Sell Home as a Short Sale

In most cases, selling while your mortgage is underwater is not a smart choice. But if you cannot make your mortgage payments and a loan modification is unavailable, then a short sale could be an option.

A short sale is when a homeowner sells their property for less than the outstanding balance on their mortgage, and the lender agrees to forgive the remaining debt. In a short sale, the profits go to the mortgage lender, not the seller, so the lender must pre-approve the sale. The borrower also must meet certain criteria and experiencing financial hardship.

Deed in Lieu of Foreclosure

If your mortgage is underwater with missed payments and you’ve been denied a loan modification or short sale by your lender, then a deed in lieu of foreclosure could be another option.

A deed in lieu of foreclosure is a document that transfers the title from the homeowner to the mortgage lender, and the lender agrees to forgive the remaining debt. However, a lender may require that the owner tries to sell the home before it considers accepting a deed in lieu.

Conclusion

An underwater mortgage can be a significant financial burden for homeowners, but options are available. If you’re in this situation, work with your lender to determine if a refinance, loan modification, short sale, or deed in lieu of foreclosure would be your best solution.