Mortgage crisis Q&A: “What is an underwater mortgage?”

I have no idea why I never touched on this topic beforeperhaps I thought it was too simple of a concept, but clearly it could use a proper explanation seeing that millions of mortgages are now underwater nationwide.

Put simply, an “underwater mortgage” is defined as a home loan with an outstanding balance that exceeds the value of the associated property.

An underwater mortgage can also be referred to as an “upside down mortgage” or a “negative equity mortgage.”

Lets look at an example of an underwater mortgage to illustrate:

Current mortgage balance: $500,000

Current house value: $400,000

Home equity: -$100,000 (negative equity)

In this rather common scenario, the borrower would be $100,000 underwater on their mortgage because they owe $500,000, yet the home is only worth $400,000.

Typically, youd see the opposite in a healthy real estate market.  The homeowner might have a mortgage balance of $500,000 and a property value of $600,000 thanks to regular mortgage payments and home price appreciation.

This would give the homeowner $100,000 in home equity. and put their loan-to-value ratio (LTV ratio) at roughly 83%.

In the underwater mortgage example, the borrower would have an LTV ratio of 125% (the lower the number the better here folks).

An LTV above 100% implies negative equity, or underwater status.  Its not good!

Why are mortgages underwater?

The underwater mortgage example above is actually pretty common nowadays for several reasons.

No, there wasnt a great flood

During the housing boom, home prices were very inflated. At the same time, scores of borrowers took out no money down mortgages. aka 100 percent financing, to qualify. And also quite simply because they could. After all, why put a bunch of money down if you dont need to, especially if you think home prices are going to rise.

Of course, when prices abruptly tanked, those who started out with no equity (100% financing) quickly fell into a so-called “underwater” position.

This problem was further exacerbated for those who opted to take out option arm mortgages. which allowed for negative amortization .

Yes, there were mortgages designed to fall into underwater positions, but everyone assumed home prices would keep rocketing to the moon.

But even homeowners who paid their mortgage payment in full each month fell into underwater positions thanks to the grossly inflated home prices.

This also explains strategic default. where homeowners choose to walk away from their mortgages because theyre so far underwater and never expect to recoup the equity.

Or simply feel they can start out fresh with a mortgage balance more closely aligned with todays home prices.

What to do if youve got an underwater mortgage

While the options arent great for those with underwater mortgages, there are certainly more and more programs being unveiled that deal with them. You may have heard about a certain government loan modification program aimed at those with underwater mortgages that allows refinancing up to 125 percent LTV its no coincidence.

And recently the government launched a program to help homeowners with underwater mortgages refinance, regardless of how deeply underwater they are.  Unfortunately, this program, known as HARP Phase II. is only available to those with Fannie Mae and Freddie Mac backed mortgages.

If you have an underwater mortgage, itd be wise to contact your mortgage lender and/or loan servicer to see what options are available for you.  You may be surprised to find that there are refinance options available to snag lower mortgage rates and even principal reduction in some cases.

Of course, there are going to be cases where borrowers are so deeply underwater that the best option could actually be walking away.  Put simply, if a borrower is so deeply underwater that it will take a decade or longer just to break even, the argument is there.

It may be better to walk away, rent for a few years, and buy again when youre ready to do.  That way you wont be waiting years for your mortgage to get back above water. Just be sure to weigh all your options and come up with a long-term plan first. Its a major decision and should be treated as such.