Underwater Mortgage: What It Is and How to Deal With It

By Bill Lyons | Published on October 3, 2023

Understanding the housing market can be challenging for anyone, including homeowners. An underwater mortgage is a term homeowners should know to help them avoid some of the negative consequences that can come with owning a home. While there are plenty of benefits to homeownership, there are also some risks involved. Although no one wants to think about those potential pitfalls, knowing what to do if they ever happen to you is essential for financial stability and peace of mind.

Knowing what an underwater mortgage is, its implications, and what to do if you find yourself with one can prepare you for the worst. Staying proactive, regularly assessing your property’s value, and being aware of market trends can help you anticipate and respond to challenges.

If faced with an underwater mortgage, there are options available to you. Knowledge and preparation are your best defense against this unforeseen hurdle of homeownership. Keep reading to learn about underwater mortgages, why they happen, how to avoid them, and what you can do if you find yourself in this situation.

What Is an Underwater Mortgage?

An underwater mortgage, also known as an upside down mortgage, isn’t a specific type of mortgage. Instead, it’s a situation in which a homeowner owes more on their mortgage than the current market value of their property. This often happens when property values decline quickly after someone purchases a home, causing the mortgage balance to eclipse the home’s worth at that point, but there are many potential causes.

If you’re upside down on your mortgage, selling your house becomes more difficult because you’ll have to take a loss. Those with an underwater mortgage might also have higher monthly payments with an adjustable-rate mortgage (ARM), making it difficult to refinance or get a home equity line of credit because of lower home equity.

How Does a Mortgage End Up Underwater?

Most mortgages end up underwater due to a decrease in property value after someone purchases a home. However, other circumstances can cause your mortgage loan to surpass your home’s value. Homeowners can become underwater on their mortgage due to various factors, such as:

Housing market declines

When property values decrease after purchase, homeowners may find that their mortgage balance surpasses the current market value of their home. This is especially prevalent when housing bubbles burst after rapid price inflations. Sudden demand and various market forces can inflate property values and, when these bubbles burst, property values drastically decrease, leaving recent home buyers with mortgages worth more than their homes.

High loan amounts

When you purchase a home with a small down payment or get a mortgage that finances most of the property’s value, homeowners may owe as much or more than the house is worth, especially if property values decline after purchase. A small down payment means you start with less equity in your home. Then, when property values decline after purchase, the mortgage balance may exceed the home’s value.

Declining neighborhood

Specific areas may see a drop in property values due to increased crime, failing schools, or economic downturns. Homeowners in these areas can end up underwater on their mortgages if the rest of the market remains stable but localized conditions worsen.

This can happen when a major employer in a specific region closes, resulting in job loss and reduced area desirability, or if the reputation of local schools falls. An uptick in crime can also diminish property values in a particular area, especially if nearby areas offer safer alternatives.

Economic impacts

Besides local economic impacts, the broader economy might also affect property values. National and global financial crises can affect the housing market, leading to recessions. Widespread economic downturns influence housing markets by resulting in job losses or reduced income, which can deter potential buyers and lead to a drop in demand and declining property values.

Personal financial strain

Personal financial strain can also cause an underwater mortgage by causing you to miss mortgage payments. By making payments on your loan, you gradually reduce the principal balance and build equity in your home. However, if you start missing payments due to financial hardships or any other reason, the unpaid interest will add to your mortgage principal, causing negative amortization.

Negative amortization can lead to a situation where the outstanding loan balance grows instead of decreasing, causing an underwater mortgage.

How to Tell If Your Mortgage Is Underwater

The easiest way to determine if your mortgage is underwater is to look at your home’s current value and compare that to your mortgage amount. However, there are red flags or signs you should look for to determine whether you might be experiencing an underwater mortgage, such as:

• Decreasing property values: If homes in your neighborhood are selling for less than their previous prices or there are many foreclosures in your area, it may indicate that property values have decreased. Of course, determining your home’s value is the only way to know if your mortgage is underwater. However, if home prices continue to fall where you live, it’s a good indicator that property values have decreased.
• A low home appraisal: A recent home appraisal can give you more accurate insight into your unique situation. If the value of your home comes back lower than your current mortgage balance, it means that your mortgage is underwater.
• Local economic downturn: If your area has experienced a local economic downturn, like a major employer closing or mass layoffs, it could lead to a decline in housing demand, which directly influences property values.
• Financial strain: If you’re experiencing financial strain and haven’t paid your mortgage, your balance may exceed your home’s value. In a volatile market, the added interest and penalties can turn your mortgage upside down, making recovering or moving that much more difficult.

The Consequences of an Upside Down Mortgage

An upside down mortgage can have serious financial and emotional consequences for homeowners. Being trapped in one of these mortgages can cause emotional stress while affecting short- and long-term financial planning. The consequences of an upside down mortgage include the following:

Limited mobility

Homeowners with an upside down mortgage will have to sell their home for its current market value, which is less than the mortgage amount, meaning they’ll have to take a loss if they want to move. Individuals with an underwater mortgage often feel stuck, with no good options for them, making moving for work or seeking other opportunities more challenging.

This lack of flexibility can affect personal and professional lives. Being stuck in a property with negative equity can prevent homeowners from pursuing many opportunities, such as relocating for better opportunities for their children or downsizing. Over time, this can lead to missed advancements, decreased earning potential, and negative emotional side effects.

Financial strain

Underwater mortgages can lead to significant financial strain, especially if homeowners miss mortgage payments and are struggling to catch up. Even for those who can afford their mortgage payments, knowing they’ll pay more for their home than it’s worth can be a constant source of stress.

Difficulty using home equity or refinancing

When many homeowners don’t like their mortgage terms, they can eventually refinance or take out a home equity loan. However, those with an underwater mortgage may find refinancing more challenging because they don’t have enough equity in the home available. This means that if interest rates change, those with an upside down mortgage may not be able to take advantage of the potential savings opportunities.

Even if a lender allows for a refinance on these mortgages, they’re often seen as high risk. The new loan’s terms may be unfavorable, with homeowners facing higher interest rates, additional fees, or stricter requirements during the process. These downsides can often negate the potential benefits of refinancing.

Higher risk of foreclosure

Homeowners who are underwater on their mortgage may be more likely to default on their loan if they can’t keep up with their mortgage payments. An underwater mortgage can place a great amount of financial pressure on a homeowner and lead to foreclosure if the homeowner can’t pay down the loan balance.

Impact on credit score

An underwater mortgage can directly lead to a foreclosure or short sale, both of which are highly detrimental to the homeowner’s credit score. This can make it difficult for them to secure home loans in the future.

But beyond housing, a poor credit score can affect various aspects of a person’s life, including higher interest rates on credit cards and challenges securing other types of loans, rental properties, and even job opportunities.

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How to Navigate an Underwater Mortgage

Being upside down on a mortgage can be a stressful, emotionally taxing experience. However, homeowners have several options and strategies available to address the situation. A few options include:

Building equity

Choosing to stay in the home and pay off your mortgage allows you to build equity as you reduce the principal balance on the mortgage. The market may change in the future, so selling when your mortgage is underwater might not make sense for you.

Over time, as you continue making regular payments and the housing market rebounds, your home’s value could appreciate. When that happens, your mortgage can become right side up again. This also gives you the opportunity to continue investing in the home with home improvements that might also increase its value.

Refinancing

Individuals upside down on their mortgages will have more limited refinancing options available to them. However, you can potentially refinance an upside down mortgage, depending on the type of loan you have. For instance, if you have a VA loan, you may be able to streamline refinance your loan if you’re having difficulty repaying it. This can help you avoid missed payments that can lead to an underwater mortgage.

You can consult with a mortgage professional to help you find the available programs and options for your specific needs. By exploring these options, you can potentially secure more favorable terms to alleviate some of the financial burdens while allowing you to continue to build home equity.

Loan modification

Some lenders may allow you to modify your loan’s terms to make it more manageable based on market conditions. Modifications might include lowering the interest rate, extending the loan length, or reducing the principal balance.

Taking advantage of these options can provide immediate relief, especially if dealing with economic hardships or unexpected financial strain. In some cases, a loan modification can mean the difference between keeping a home and facing foreclosure, but you should approach your lender proactively to discuss your unique situation.

Short sale

A short sale occurs when a lender allows a homeowner to sell their property for less than the amount owed on the mortgage. This means that a homeowner may not have to take a loss on the home if they choose to sell. The proceeds from the sale go to the lender, who might then forgive the remaining balance.

Keep in mind that while a short sale can provide a way out of an upside down mortgage, it can still have a negative impact on the homeowner’s credit score.

Renting the property

Renting the property is another good option if you have to move for a job or another opportunity while your mortgage is underwater. Renting your home may offset some of the mortgage costs while allowing the property to potentially appreciate over time. The money earned in rent can be used to cover your mortgage payments, allowing you to live somewhere else and wait for the market to improve.

Additionally, becoming a landlord can offer potential tax benefits related to the property’s depreciation and other expenses. However, you should conduct research on the local rental market to set comparative rental rates and ensure consistent occupancy.

Filing for bankruptcy

While this is a last-resort option, filing for bankruptcy might provide relief for some homeowners with an underwater mortgage. Depending on the chapter filed, the homeowner may be able to restructure their debt or be relieved of certain obligations.

However, filing for bankruptcy comes with significant credit implications. It can remain on your credit report for many years, making it difficult to secure other loans or credit cards with favorable terms later on.

Tips for Avoiding an Upside Down Mortgage

While no one can predict the future, it’s possible to minimize the risk of an underwater mortgage by being proactive before and after purchasing a home. Understanding the real estate market and making informed decisions can reduce the chances of ending up owing more on a property than it’s worth.

Making a larger down payment

While plenty of options for small down payments are available, buyers should try to contribute as much as possible upfront. A large down payment reduces the loan amount while creating a safety net against volatility. If the property experiences lower value, the down payment can ensure you don’t immediately have an underwater mortgage.

Higher down payments also make for lower-risk loans for lenders, potentially qualifying you for better terms and more favorable interest rates, offering both short- and long-term savings.

Contributing more to your principal

With most mortgages, every mortgage payment you make covers interest and some of the principal amount. By paying more than the required monthly amount, you can increase the equity in your home faster. Then, even if property values fluctuate, you’ll have a buffer because you’ve already built more equity in the home.

This strategy can also lead to long-term savings because it reduces your principal, leading to less interest accrued over the life of the loan.

Choose fixed-rate mortgages

A fixed-rate mortgage may be particularly appealing to those on a fixed income or budget-conscious homeowners who want more consistency and transparency, knowing their monthly payments won’t change unexpectedly. In a fluctuating economy, they provide peace of mind that allow homeowners to navigate challenges more easily than with adjustable-rate mortgages.

Adjustable-rate mortgages typically come with lower interest rates for a set period of time. However, the risk of these loans is that future market conditions can cause significant rate increases. On the other hand, fixed-rate mortgages may have higher interest rates but offer a more consistent interest rate throughout the life of the loan.

This gives borrowers more stability, improves long-term financial planning, and safeguards against unforeseen interest spikes that could lead to missed payments or your outstanding balance to push your mortgage underwater.

Consider your budget

Before you purchase a home, consider your budget and how much you’re comfortably willing to borrow. While you may be able to borrow a certain amount, it may not make financial sense to get the highest loan amount just because you can. Overextending yourself can lead to financial strains that affect your ability to repay your mortgage.

To ensure timely payments, choose a property that’s comfortably within your budget to guarantee you won’t have to worry about your mortgage if you experience financial hardship.

Need help creating a budget for your next home purchase? Download the Griffin Gold app to effectively manage your money and access budgeting tools that make it easy to track your spending.

Research the market

Before purchasing a home, research the local market, including trends and historical data. Choose neighborhoods with consistent track records of property appreciation to reduce the chances your investment will lose value.

You can also analyze development plans for the area, such as community projects that influence property values. Being informed about the area before you decide to buy can help you make a better purchasing decision.

Monitor home values

As a homeowner, you should monitor home values to determine when it might be time to sell. Tracking local property values and being alert to trends can help you anticipate changes and adjust your strategy, ensuring your mortgage never goes underwater. Using the Griffin Gold app, you can monitor your home’s value while on the go and review reports and analyses related to your local housing market.

Periodic home appraisals can also help you gauge your property’s value more accurately. Understanding factors like school ratings, commercial developments, and transportation improvements can provide clues about potential future property value fluctuations.

Don’t refinance too often

When you refinance your home, you replace your existing mortgage with a new one with different terms or interest rates. Many homeowners refinance to get lower rates, consolidate debt, or adjust the length of the loan. However, continuously hunting for better terms can eat into your equity.

When you refinance your home, you’ll have additional costs like appraisal fees, closing costs, and other related expenses. If you refinance multiple times in a short span, these costs can accumulate.

Additionally, the temptation to pull a significant amount of cash out of your home can make you more vulnerable, so it’s crucial to compare the short-term gains to the long-term consequences to determine if repeatedly tapping into your home’s equity is worth the risk of going underwater on your mortgage.

Discuss Your Options With a Mortgage Professional

An underwater mortgage can cause significant emotional and financial strain. While no one can predict every aspect of the housing market, there are several ways you can reduce the risk of a mortgage ending up upside down. Potential homeowners can take various proactive measures before purchasing a home, such as researching the area, while current homeowners can continue to monitor property values to determine the right time to sell.

Avoid an underwater mortgage by finding the right loan in the first place. Griffin Funding is a trusted mortgage lender that works closely with clients to identify the right financing product for their unique situation. With a team of knowledgeable professionals, we offer mortgage solutions designed to fit your individual needs to ensure you start your homeownership journey on a secure footing.

Contact us to learn more about our mortgage options, whether you’re a new borrower or a current homeowner looking to refinance. Or, if you’re ready to get started, you can apply for a mortgage online today.

Bill Lyons

Bill Lyons is the Founder, CEO & President of Griffin Funding. Founded in 2013, Griffin Funding is a national boutique mortgage lender focusing on delivering 5-star service to its clients. Mr. Lyons has 22 years of experience in the mortgage business. Lyons is seen as an industry leader and expert in real estate finance. Lyons has been featured in Forbes, Inc., Wall Street Journal, HousingWire, and more. As a member of the Mortgage Bankers Association, Lyons is able to keep up with important changes in the industry to deliver the most value to Griffin's clients. Under Lyons' leadership, Griffin Funding has made the Inc. 5000 fastest-growing companies list five times in its 10 years in business.