An "upside-down" or "underwater" mortgage is where the remaining principal balance exceeds the property's fair market value. That might happen for several reasons, but it's often tied to plunges in the economy.
Many homeowners rushed to dump their upside-down homes when housing prices declined in 2005, but others held on. They watched their home prices collapse, and many probably felt like they were the captain standing on a sinking ship.
The good news is there are many options available if you find yourself in that situation. Lenders almost invariably lose money in foreclosure situations, so you might have more bargaining power than you think.
- Your bank might be willing to reduce the principal to match the market value of the home.
- You might be able to short-sell the home for the market value and not owe anything else.
- Loan modifications and refinancing options might be available through your bank or government programs.
- Options with less-desirable outcomes include walking away, giving the home to the bank, or filing for bankruptcy.
Stay the Course
Home values are much like stock values: they rise and fall following trends in investor sentiment and economic and market conditions. If you can afford to stay in your home and keep making mortgage payments, it is the least problematic and best method to reverse the upside-down mortgage.
Your home's value has a good chance to rise. On the same note, there is just as good a chance that it will drop or not rise at all. In any case, continuing to make payments pays off the interest on your loan and begins to pay off the principal, which begins to bring your mortgage right side up.
You might also make some improvements that will add value to your home, such as kitchen and bathroom updates (again, if you can afford to).
A Principal Reduction
Another good solution for your upside-down house is to turn it right side up again through a principal-reduction program.
The problem with this option is that your bank would have to forget about and forgive that portion of the mortgage debt that is not covered by the value. Not every bank will do that, but it doesn't hurt to ask.
It might seem counterintuitive that the bank would refuse a principal reduction because it would want to make a short sale, which also involves forgiving the debt. At the same time, you might wonder why the bank won't forgive the debt for you—a borrower who has made payments on time and is in good standing with the bank—rather than a third-party buyer.
That would be an excellent question to ask your bank if you try to negotiate a reduction deal.
The Short Sale Solution
A short sale is probably your second-best option from a purely financial perspective, right after a principal reduction.
A short sale gets rid of the mortgage debt, and the process will free you from the obligation and liability of the mortgage, at least in some states. The bank agrees to let you sell your home for its fair market value, even if that value is less than your loan balance.
A short sale can be less costly for the bank than a foreclosure.
There are many different types of short sales, so talk with an experienced short-sale agent to figure out which is best for you. The expertise of an experienced agent can make the difference between you getting cash for your short sale or having the bank reject your short sale entirely.
Your bank might prefer to modify your mortgage. This process can lower your monthly payments, but it will extend the term of your loan to compensate. This method is generally used by homeowners who want to keep the home they have, regardless of the amount of money they're spending on it over the long run.
Homeowners who choose this route are typically employed and can afford their monthly payments. However, they tend to pay more than one-third of their gross monthly income, prefer to keep the home, and would like to find a way to reduce their payments.
The Refinance Solution
The federal government established a housing-assistance program following the large decline in home values after the financial crisis of 2007 to 2009. Called the Home Affordable Refinance Program (HARP), it helped more than 3.5 million homeowners refinance their Fannie Mae and Freddie Mac mortgages. However, the program expired in December 2018.
Fannie Mae and Freddie Mac have designed replacement programs for underwater homeowners. The Freddie Mac Enhanced Relief Refinance program allows homeowners with Freddie Mac mortgages or loans not refinanced through HARP before December 31, 2018, to refinance their homes.
Fannie Mae offers a High Loan-to-Value Refinance option for homeowners that are upside-down as well. Only Fannie Mae mortgages may be refinanced, and they need to have a note date of October 1, 2017, or later.
Most borrowers who apply for a refinance do so because they want to keep their homes and lower their monthly payments and interest rate.
The main drawback is that refinancing doesn't reduce your principal balance, and you'll need to have a government-sponsored loan. A mortgage through a bank will generally not be refinanced if it is underwater—most banks require equity in a home to be approved.
Just Walk Away
Walking away (also called a "strategic default") from a mortgage payment may seem like a good idea at first. It's easy to become fed up after trying to work within a bank's system, only to fail to resolve a situation that wasn't your fault. Many frustrated and angry homeowners tend to stop making mortgage payments and send the home to foreclosure.
You might think you're "sticking it to the bank" by doing this, but you'll most likely only end up hurting yourself. Your credit will be affected, the bank will foreclose, and you'll probably have to wait another seven years before you can qualify for a mortgage again. Strategic default is an option, but it isn't a very good one if you need your credit.
Give the House to the Bank
You can't give a house back to the bank, because the bank didn't own it in the first place. A bank might seize a foreclosure home, claiming the collateral for the loan, but it doesn't "take it back" per se.
Banks will sometimes offer to let owners deed their properties to them, however. This process is called a "deed-in-lieu of foreclosure." You're effectively saying, "I'm not going to make any more mortgage payments, but you don't have to foreclose, because I'm just going to give you the property." This arrangement is often in the bank's best interest, but rarely is it in the owner's. Your credit will still take a hit, and you're not likely to walk away with anything more than you would have if you'd defaulted and gone into foreclosure.
The Bankruptcy Solution
Bankruptcy is (or should be) your last-ditch effort, particularly if your upside-down home is your only financial problem. But you might consider filing for bankruptcy protection if your other debts have gotten out of hand, and you desperately need some financial relief.
A Chapter 7 bankruptcy filing erases or "discharges" your remaining debts after the trustee takes possession of any non-exempt property you own and sells it to satisfy as much of what you owe as possible.
A Chapter 13 bankruptcy involves entering into a multi-year payment plan to pay off your debts under the supervision of the court. The terms tend to be better than those you're struggling with.
You'll most likely lose your home in a Chapter 7 proceeding, but you might be able to salvage it in a Chapter 13 bankruptcy. That is because your mortgage payments are typically included in your payment plan.