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Updated on Thursday, October 10, 2019
There are some things you can’t control as a homeowner, such as natural disasters, neighbors or the direction of home values. If these happen to take a nosedive, you could watch the equity you’ve built in your home disappear.
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In fact, more than 5 million homeowners are “seriously underwater” on their mortgages — meaning the amount of debt attached to their home is at least 25% higher than the home’s value, according to the latest data from ATTOM Data Solutions, a property research firm. If you’re one of these homeowners, don’t despair. There are ways to rebuild the equity on an underwater mortgage. In this guide, we’ll explain what it means to have a mortgage underwater and how to rebuild the equity you’ve lost.
What is an underwater mortgage?
An underwater mortgage is a loan with an outstanding balance that exceeds the value of the home it secures. This is also referred to as having negative equity or being upside down on your mortgage.
There are a few ways that a mortgage can become underwater:
- Significant drop in home values
- Multiple loans taken out against a home, and the total balance is higher than the home’s value
- Monthly payments not covering the interest due on a mortgage (negative amortization), and the balance owed grows instead of shrinks
If you tried to sell your home while it’s underwater, the sales proceeds likely wouldn’t be enough to pay off your mortgage, which would leave you on the hook for the remaining balance. You’d also have a hard time refinancing your mortgage, since you need to have some equity available for a refinance in many cases.
How to tell when my mortgage is underwater
If your current mortgage balance is higher than your home’s current market value, then your mortgage is underwater.
For example, let’s say your home was worth $250,000 when you first bought it, and you took out a $200,000 mortgage with a 4% interest rate. Five years later, the economy takes an unfortunate tumble and home values drop by an average 40%, giving your home an approximate $150,000 value.
Based on your loan’s amortization schedule, the outstanding balance you’d owe in year five would be about $180,000. That leaves you with $30,000 in negative equity.
Negative Equity in Your Home
Estimated Home Value in Year 5
Estimated Mortgage Balance in Year 5
If you find yourself in a situation similar to the one described above, there are options available to help you rebuild your home equity, which we’ll discuss in the next section.
How do I rebuild equity?
Just because your mortgage is underwater doesn’t mean it has to stay that way. There are ways to start rebuilding the equity you might need to fund other financial goals.
Pay down your mortgage as usual
The most straightforward option is to continue to pay down your mortgage as you normally would. Perhaps the housing market will recover, leading to an eventual rise in home prices. Either way, as long as you’re submitting your mortgage payments in full and on time, you’ll pay it off on schedule.
You can help speed things along by paying extra toward your principal balance. There are several ways to tackle this, which might include adding a couple hundred dollars — or whatever amount is comfortable for you — to your mortgage payment each month.
Another option is to make biweekly payments instead of monthly payments. This can add up to one extra payment each year. That’s because there are 52 weeks in a year and you’d make 26 half payments, which equals 13 full payments.
Be sure to ask your mortgage lender or servicer to direct any extra money you pay on your loan toward your principal balance (not interest).
Modify your mortgage
If you’re experiencing a temporary hardship on top of your underwater mortgage and are struggling to keep up with your mortgage payments, you could benefit from a mortgage modification.
A modification is when your lender changes the original terms of your mortgage to make it more affordable for you. Changes might include:
- Extending the number of years you have left to repay your mortgage
- Lowering your mortgage interest rate
- Reducing your outstanding principal balance
- Switching your mortgage rate type from adjustable to fixed
Eligibility requirements vary, so it’s best to contact your lender for more information about how to modify your loan.
Recast your mortgage
Another way your lender can make tweaks to your existing mortgage is by recasting your mortgage — especially if you’ve recently come into a financial windfall.
A mortgage recast involves paying a lump sum of money toward your outstanding principal balance. Your lender then recalculates your monthly mortgage payments based on the lower principal balance, but your mortgage rate and term length stay the same.
You’ll need to pay at least $5,000 — sometimes more — to recast your mortgage, and you might also be charged a recasting fee, up to $500. Check with your lender for more details and requirements.
Conventional loans typically qualify for mortgage recasting, but not government-backed loans, such as those insured by the Federal Housing Administration (FHA loans) or Department of Veterans Affairs (VA loans).
Refinance your mortgage
Although the Home Affordable Refinance Program (HARP) — a government-sponsored initiative that helped nearly 3.5 million homeowners refinance their mortgages — has expired, there are other programs available that provide similar assistance.
Fannie Mae and Freddie Mac, the two major agencies that buy and sell mortgages to and from lenders that follow their guidelines, created new initiatives as HARP was ending to address those homeowners who were underwater on their conventional mortgages or have high loan-to-value (LTV) ratios. An LTV ratio is calculated by dividing your loan amount by your home’s value. Revisiting the underwater mortgage example above of a home worth $150,000 with a $180,000 mortgage balance, the LTV ratio is 120%.
Fannie Mae’s high LTV refinance option offers homeowners with an LTV ratio above 97% the opportunity to refinance their mortgage. Homeowners must be current on their mortgage payments and benefit from at least one of these options:
- A reduction in the principal and interest portion of their monthly payment
- A lower interest rate
- A shorter loan term
- A more stable mortgage, such as a switch from an adjustable-rate to a fixed-rate loan
There is no maximum LTV ratio for fixed-rate mortgages, but adjustable-rate mortgages (ARMs) have a 105% LTV maximum. The existing mortgage must be Fannie Mae-owned.
The Enhanced Relief Refinance mortgage offered by Freddie Mac also requires homeowners to be current on their mortgage payments and have an LTV ratio that is higher than allowed for a standard refinance. The maximum LTV ratio allowed for ARMs is 105%; there’s no maximum for fixed-rate loans.
Homeowners must benefit from a shorter loan term, lower principal and interest payment, lower mortgage rate and/or a move from an ARM to a fixed-rate mortgage.
If you have a government-insured mortgage — FHA, USDA or VA loan — you may be able to take advantage of a streamlined refinance, which typically has a limited credit documentation and underwriting process. Additionally, you may not need an appraisal to verify your home’s value.
- FHA: FHA borrowers applying for a streamlined refinance must be current on their mortgage payments and benefit from at least a 5% reduction in their monthly payment amount. You may also qualify if you’re switching from an ARM to a fixed-rate mortgage or shortening your loan term.
- USDA: Borrowers with USDA loans may qualify for the streamlined assist refinance option if they have little to no equity and are current on their payments. The benefit must come from a monthly mortgage payment that’s at least $50 lower than the existing amount.
- VA IRRRL: The VA Interest Rate Reduction Refinance Loan program helps homeowners with VA loans by lowering their mortgage payment through a reduced interest rate. Guidelines require a minimum 0.5% rate reduction.
Other options for underwater homeowners
If you’re ready to walk away from your home or simply can’t afford it anymore, consider one of the avenues below:
You could attempt to sell your home, with the understanding that you likely won’t make enough profit to pay off your mortgage. If you have a hefty savings account, you can use some of those funds to pay the difference between the amount your home sale covers and your outstanding loan balance.
Another option is a short sale, which allows you to sell your home for a price that is less than the outstanding balance on your mortgage. Additionally, your mortgage lender may forgive your remaining mortgage debt. Keep in mind that your credit score will take a hit with this option — it could drop by 100 points, according to FICO.
Deed in lieu of foreclosure
A deed in lieu of foreclosure, also known as a mortgage release, is the process of voluntarily transferring the ownership of your home to your lender. In exchange, you may be released from your mortgage payments and debt. This option also prevents you from going into foreclosure.
Similar to short sales, a deed in lieu of foreclosure negatively impacts credit scores.