An "upside-down" or "underwater" mortgage is one where the remaining principal balance exceeds the fair market value of the property. This might happen for any number of reasons, but it's often tied to plunges in the economy.
Many homeowners rushed to dump their upside-down homes when housing prices began to decline in 2005, but others held on. They watched their home prices collapse and many probably felt like they were the last captain standing on a sinking ship.
The good news is there are many options available if you find yourself in this situation. Lenders almost invariably lose money in foreclosure situations, so you might have more bargaining power than you might think.
A Principal Reduction
The very best solution for that upside-down house is to turn it right side up again. One way to do this 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's not covered by the value. Not every bank will do this. In fact, very few banks will, but you should ask just to be sure.
It might seem counterintuitive that the bank would refuse a principal reduction because it would probably be willing to do a short sale, which also involves forgiving the debt. You've got to 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 point of view, 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 basically 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.
Some homeowners don't care that they'll probably owe more than their properties are worth for years and years if they choose a loan modification. Your mortgage balance might be meaningless in comparison to the way you feel about your home.
You don't want to move under any circumstances. You'd be happy if your lender will just lower your monthly payment. Homeowners who go this route are typically employed and they can afford their payments, but their mortgage payments make up more than 1/3 of their gross monthly income. They're satisfied if they can just pay less than that.
The Refinance Solution
The previous HARP program was pretty much a failure, so the government modified it. HARP was offered only for existing Fannie Mae and Freddie Mac loans as of 2018, then it even that version expired on Dec. 31, 2018.
Freddie Mac then offered an Enhanced Relief Refinance program if it owned your loan. You must have made on-time mortgage payments for at least six months to qualify, and you can't have been more than a month late with any payment in the last year.
You can't have previous refinanced through HARP, and some other restrictions apply as well.
Most borrowers who apply for a refinance do so because they want to keep their homes and they want a lower monthly payment in addition to a lower interest rate.
The main drawback is that refinancing won't reduce your principal balance, and a traditional refinancing through a bank is pretty much off the table if you're underwater. You must typically have equity in your home to be approved.
Just Walk Away
Pain can quickly develop into hostility after a homeowner tries to work within a bank's system, only to fail to reach a resolution. These 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," but you'll mostly likely only end up hurting yourself. What it will do to your credit can be just the tip of the iceberg. You'll probably have to wait another seven years before you can qualify for a mortgage again. There are better choices than foreclosure for a homeowner.
Give the House Back
You can't technically give a house back to the bank because the bank didn't own it in the first place. A bank might seize a home in foreclosure, claiming the collateral for the loan, but it doesn't "take it back."
Banks will sometimes offer to let owners deed their properties to the bank, 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 is often in the bank's best interest, but rarely it's in the owner's interest. Your credit will still take a hit and you're not likely to walk away with anything more than you would in a foreclosure situation.
The Bankruptcy Solution
This is pretty much a 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 court 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 payment plan to pay off your debts over a period of years under the supervision of the court, usually at better terms 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. Your mortgage payments are typically included in your payment plan.
At the time of writing, Elizabeth Weintraub, DRE # 00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.