Underwater Mortgage: Meaning, Overview, History

What Is an Underwater Mortgage?

An underwater mortgage is a home purchase loan with a higher principal than the free-market value of the home. This situation can occur when property values are falling. In an underwater mortgage, the homeowner may not have any equity available for credit. An underwater mortgage can potentially prevent a borrower from refinancing or selling the home unless they have the cash to pay the loss out of pocket.

How an Underwater Mortgage Works

Underwater mortgages were a common problem among homeowners around the height of the 2008 financial crisis, which, among other things, involved a substantial deflation in housing prices. While the market has greatly recovered due to support from monetary policy and interest rate stabilization, underwater mortgages are still a factor that property owners must follow closely when making a real estate investment.

Generally, a mortgage is considered underwater when the value of the home is less than the original mortgage principal. Depending on the decrease in the home's value since its purchase, the borrower may also have no equity or negative equity. Equity on a home is associated with the value of the home versus the balance paid. A borrower with a $250,000 mortgage that sees their home value decrease to $225,000 is considered to have an underwater mortgage. If the borrower has paid half of the principal on their mortgage loan resulting in a principal balance of $125,000, then they still are considered to have positive equity of $100,000 which could be utilized in a home equity loan.

The 2008 Financial Crisis

The 2008 financial crisis had numerous effects on the United States economy. One such effect was a bursting housing bubble that substantially deflated real estate property values across the market. A primary catalyst for the housing value deflation was loose lending standards for borrowers, providing for broader mortgage loan approvals. This loose lending, specifically to subprime borrowers, led to a heightened number of defaults and foreclosures, which affected real estate property values across the U.S. market. This led to a variety of uncommon situations causing losses for borrowers across the market whose mortgage loan values exceeded their home’s fair market value.

Subsequently, the implementation of monetary policy by the Federal Reserve helped the U.S. economy recover and housing prices rebound. Lower interest rates following the crisis also helped reduce mortgage payment burdens and increase demand for real estate.

Assessing Home Value

Given that new market initiatives from the Dodd-Frank legislation are helping to improve mortgage lending standards, it's unlikely that homebuyers will again see the substantial real estate price drops that occurred in 2008. However, the 2008 financial crisis did cause a new sense of market realization and caution across real estate investing. As such, lenders are now more cautious about the mortgages they approve, and homeowners are generally more careful about the mortgage debt they take on. Even with a new outlook on the market, though, homeowners still must closely follow home values and mitigate underwater mortgage risks.

To understand a home’s value, a homeowner may choose to have the property appraised annually. Appraisals are also done regularly to calculate property taxes. An appraisal value will be based on several factors, including national market trends, recent sales by similar properties in the region and neighborhood, and the home’s individual amenities. Homeowners can also work to maintain a high home value for their home by doing regular renovations and actively supporting positive community activities.

If someone finds themselves stuck with an underwater mortgage, working with one of the best mortgage refinancing companies is a solid way to potentially rid themselves of this burden.

The Bottom Line

No one wants to hear their mortgage is underwater, since it means they owe more than the home is worth and it can make it difficult to sell the home. However, if your mortgage is underwater, you still have options. You could stay in the home and build equity, refinance your mortgage, opt for a short sale, or walk away. Speaking with a financial advisor about your situation can help you determine a financial strategy that's best for you.