Is your mortgage underwater? Here’s what you should do

Homeownership is an exciting milestone that represents stability and a sense of accomplishment. Unfortunately, despite the best of intentions and careful financial planning, circumstances can change. 

From rising interest rates to unforeseen market shifts, an underwater mortgage can leave homeowners in a major financial deficit. What makes this situation so frustrating is that it can happen even if you’ve diligently paid your mortgage on time — in other words, through no fault of your own. 

Thankfully, there are options. An underwater mortgage doesn’t need to drag you down with it, and there are ways to keep yourself afloat while you right-size your mortgage. 

What is an underwater mortgage?

An underwater mortgage—also known as negative equity or being “upside down” on a mortgage—happens when the outstanding balance of a mortgage loan exceeds the current market value of the property it’s secured against. In short, it means the homeowner owes more on the mortgage than their home’s worth. 

In many cases, an underwater mortgage limits a homeowner’s ability to sell the property without incurring a loss. It can also keep them from refinancing the mortgage at more favorable terms. With these two options nullified, homeowners are stuck with negative equity—and it can feel like being tied to an anchor. 

How does a mortgage end up “underwater?”

Mortgages can go “underwater” for several reasons, and some of them involve no fault on the part of the homeowner. Some of the most common reasons why homeowners find themselves in a negative equity situation include:

Decline in home value

One of the most significant factors in causing negative equity is a decline in the value of your home. Just like any other asset, the value of real estate fluctuates over time. If you purchased your home during a period of high home values, but the market then declined, you could find yourself owing more on your mortgage than the home is currently worth. For instance, if you purchased a home for $300,000 and the value fell to $250,000, you would owe more than your home is worth.

Learn how much your home is worth with a free valuation — our estimates are 30% more accurate.

Overvaluation during purchase

In some cases, homeowners go underwater on their mortgage thanks to overvaluation during the purchase process. If appraisals or valuations at the time of purchase were inflated, homeowners could end up owing more than the true market value for the property. Working with a reputable appraiser can help you avoid this problem.

High-interest rates

The interest rate you receive on your mortgage can significantly impact your ability to build equity. If you have a high-interest rate, much of your monthly mortgage payment will go towards interest rather than principal. This can result in a slower accumulation of equity and make it more challenging to build up your home's value. Additionally, if you need to refinance your mortgage to lower your interest rate and payment, it will be harder to do that if your loan is underwater.

Large down payment

If you put a large down payment on your home, this can be a disadvantage for you if the home value drops. For example, if you put a 20% down payment on a $200,000 home, you pay $40,000 upfront. If the home value falls by 10%, your $200,000 home is now worth $180,000, and you've lost $20,000 of your investment. You may still be responsible for the original mortgage amount regardless of the home's current value. This can result in a significant loss of equity if home values start to decline.

What are the consequences of an underwater mortgage?

An underwater mortgage is devastating and consequential for homeowners. Some of the larger implications of an underwater mortgage include:

Additional financial burdens

When you find yourself in an underwater mortgage, you may face financial burdens that can significantly impact your quality of life. You may notice that your home is worth less than you owe, so refinancing is not an option. Homeowners may then be unable to sell the property and must continue making mortgage payments on a home they cannot afford or benefit from. This situation may force the homeowners to consider additional sources of income or cut back on their expenses to sustain their current living arrangements.

Impact on your credit score

An underwater mortgage situation can have a severe impact on your credit score. Homeowners who cannot afford to make their mortgage payments and start falling back on their commitments can suffer from poor credit scores. Late payments and defaults are among the reasons why your credit score could decrease. It can also affect your future borrowing, including future mortgage options, vehicle loans, and other lines of credit.

Emotional and mental health impact

Dealing with financial trouble can be a stressful experience that takes a significant toll on your mental health and well-being. Living with the financial stress of an underwater mortgage can cause depression, anxiety, and other existential crises. It's difficult to live every day with a financial burden that is affecting your credit score, relationships, and other aspects of your life. Understanding that you are not alone and seeking professional help can be an excellent step toward finding a solution.

Legal implications of walking away

When homeowners realize that they cannot afford their mortgage and are stuck with an underwater mortgage, they may consider walking away from the property or allowing foreclosure on their home. However, there could be severe legal implications for this decision. Foreclosure can stay on your credit report for years, and you may settle your debt even after foreclosure by selling your property.

What can you do if you have an underwater mortgage?

Regardless of why your mortgage is underwater, you’re facing a challenging situation. Don’t lose hope. Here are effective strategies and steps you can take to right the ship and avoid significant losses if you currently have (or are anticipating) going underwater on your mortgage:

Keep paying your mortgage

The most straightforward way to cope with an underwater mortgage is to keep making your mortgage payments on time. This option can help you maintain your credit score and avoid foreclosure. If you have any issues making payments, consider discussing refinancing or modification options with your mortgage provider.

Rent out your property

Another option to consider is renting out your property to cover your mortgage payments. If you're hesitant to move or have difficulty selling your home, renting it out could be a viable option. The rental income could help you reduce the financial strain and increase your cash flow. You could even use the extra money to pay down the principal or cover your other debts.

Also, you may not even need to move out of your property to generate some rental income. Renting out a guest suite or other unused area of your property as an AirBnB could be a viable option to mitigate your financial challenges. Short-term rentals can generate some significant additional income, but make sure you’re aware of local regulations, HOA rules, and tax implications.

Related: Should you rent or sell your house?

Apply for a loan modification

A loan modification may be a good option to consider if you're struggling to make payments. It involves negotiating with your lender to change the terms of your mortgage, such as the interest rate, payment schedule, and loan duration. In some cases, a modification could reduce your monthly payment and allow you to keep your home but there is no guarantee. Keep in mind that applying for a loan modification could be a lengthy process and could impact your credit score.

Explore refinancing options

Refinancing your mortgage is another option for homeowners who have an underwater mortgage. The refinancing process involves obtaining a new loan with better terms to pay off your current mortgage. Refinancing could help you reduce your interest rate, lower your monthly payments, or change your loan term. However, keep in mind that refinancing could take time and could have fees and closing costs.

Sell your property

If you're unable to keep up with your mortgage payments and none of the options above work for you, selling your property could be the best option. While it may be hard to part with your home, a short sale could help you avoid foreclosure and reduce the financial burden. A short sale involves selling your property for less than what you owe on the mortgage. Your lender would need to approve the sale, but it could be a more viable option than foreclosure. 

Learn how to sell your house fast

If your mortgage is underwater, you have options

While living with an underwater mortgage can be stressful, it’s important to remember there’s hope and options available for homeowners. Whether you seek professional advice from financial advisors or you research solutions like loan modification or government assistance, by staying proactive and well-informed, you can navigate the housing market with confidence and minimize the effects of a negative equity situation.

The circumstances that led to your underwater mortgage might have been beyond your control, but the situation is far from hopeless.