An underwater mortgage, also called an upside-down mortgage, occurs when the loan’s principal balance is higher than the home’s fair market value, resulting in negative equity. In other words, a mortgage becomes underwater when you owe more than your home is worth, and your loan-to-value ratio exceeds 100%.

Around 270,000 Americans who borrowed a mortgage to buy a home in 2022 are now at least marginally underwater, according to a Dec. 5 report from Black Knight, a mortgage analytics company. While this may sound alarming, negative equity rates are still far below historical averages.

It can be distressing to have an underwater mortgage, but it’s not necessarily a cause for panic. A mortgage can become upside-down when your property’s value drops for reasons beyond your control, such as during a housing market downturn. But if your mortgage is underwater because you simply haven’t been making payments – and the unpaid interest has become an unmanageable burden – then you may need to take more serious action.

What you should do with an underwater mortgage depends on the severity of the upside-down loan amount and your own financial circumstances. Here are five strategies for getting out of an underwater mortgage.

Stay Put and Keep Paying Down Your Principal

Being underwater on a mortgage isn’t uncommon, particularly for new homeowners who haven’t had much time to pay down their mortgage principal. Negative equity is even more prevalent among buyers with a small down payment, such as those who borrowed an FHA or VA loan, according to Black Knight.

Let’s say you bought a home for $350,000 with a 5% down payment, meaning your initial home loan amount was $332,500. After seven months of making on-time payments at a 6% mortgage rate, your loan balance would be paid down to around $330,000. At the same time, however, home values in your neighborhood dropped meaningfully, and your home is now worth $320,0000. This means you’re about $10,000 underwater on your mortgage with a loan-to-value ratio of 106%.

In this circumstance, it may be advisable to simply keep making mortgage payments and take no further action. This way, you can keep your home without any negative impact to your finances or credit score. After a repayment period of months or years, you’ll have paid down your mortgage principal – and home values are also likely to rebound over the long term. This option can be best if you don’t have an immediate need to sell your home, such as job relocation or divorce.

You may also decide to make additional payments toward the principal balance in order to get back on track faster, if you have the extra cash flow to do so. But since you have negative equity in your home, it will be difficult to sell or refinance your home – unless you have the cash upfront to cover the underwater loan amount. Plus, selling or refinancing your home after such a short time would undoubtedly be more expensive than simply staying put.

Discuss Solutions With Your Mortgage Lender

In more dire circumstances, it may be pertinent to reach out to your mortgage lender to discuss your options. For example, if you can’t keep up with your monthly payments or if you need to relocate and sell your home, you may be able to use one of these strategies:

Loan Modification

A loan modification is when the lender permanently changes one or more of your loan terms. It may be possible to lower your monthly payment, for example, by extending your repayment term or reducing your interest rate. In some cases, the lender may be willing to lower your principal balance, although you may need to pay taxes on the forgiven amount. And unlike foreclosure, a loan modification allows you to stay in possession of the property, so you don’t lose the roof over your head.

Short Sale

A short sale is the transaction of a property in which the lender accepts a sales price that’s less than the remaining mortgage amount owed by the current homeowner. The lender may be willing to settle the difference for less than what’s owed, or it may forgive the negative equity amount altogether. A short sale is generally a better alternative to foreclosure for all parties involved; it’s less expensive to the lender and it’s less damaging to the homeowner’s credit history.

Deed-in-Lieu of Foreclosure

A deed-in-lieu allows you to forfeit ownership of your home to the lender, usually to prevent the foreclosure process. Through this option, you avoid being personally liable for any remaining amount owed on the mortgage. If you’re underwater on your mortgage, you may need to ask the lender to waive the negative equity during this process. Make sure you get any agreement in writing, so you aren’t held responsible for the underwater loan amount down the line.

Agreeing to a short sale or deed-in-lieu can help you avoid foreclosure, which can have a negative impact on your credit score and your ability to buy a home in the future, but you’ll forfeit your home under these options. A loan modification can help you get out of being underwater on your mortgage if you want to keep ownership of the home. Keep in mind that any amount of negative equity forgiven by your mortgage lender can count as income, so plan for tax season accordingly.

Refinance Through a Government-Sponsored Program

It’s not typically possible to refinance a conventional mortgage that’s underwater, since many lenders require applicants to have at least 20% equity in their home. Although some lenders may accept applicants with a loan-to-value ratio that exceeds 80%, it’s unlikely that a lender would let you refinance with an LTV over 100%.

There are some exceptions for government-backed mortgages, including streamline refinancing for FHA, USDA and VA loans. Whereas the maximum amount you can refinance is typically based on a home appraisal, the process is different for a streamline refinance.

There are no home appraisal requirements for streamline refinancing – instead, the maximum refi amount is based on the outstanding balance of the existing mortgage. It’s possible to use a streamline refinance to lower your interest rate or shorten your repayment term, which can help you pay down your principal (and get out from being underwater) faster.

Additionally, Freddie Mac and Fannie Mae both have special refinancing programs for underwater mortgages, but they’ve temporarily stopped taking applications due to low volume. If demand were to rise due to an increasing number of upside-down mortgages, then these programs – the Freddie Mac Enhanced Relief Refinance and the Fannie Mae High Loan-to-Value Refinance Option – may resume in the future.

File for Bankruptcy

Declaring bankruptcy can have serious and long-lasting consequences on your credit score, but it may provide much-needed relief if you’re underwater on your mortgage.

Chapter 7 bankruptcy can wipe out your debt, including your mortgage obligation, but you’ll lose your home in the process. This type of bankruptcy can provide you with a fresh start, and it’s typically better than letting the bank foreclose on your home. With foreclosure, you may owe taxes on the cancelled loan amount – but with Chapter 7, your discharged mortgage debt doesn’t count as income.

Chapter 13 may provide a better option if you want to get out from being underwater while still keeping your home – especially if you have a second mortgage like a home equity loan or HELOC. Filing for Chapter 13 bankruptcy won’t modify the loan amount on your primary mortgage, but it can reduce the amount you owe on an upside-down second mortgage. Through a process called lien-stripping, the second mortgage is converted to an unsecured debt, allowing you to repay it for less than what you owe.

Whether or not you should declare bankruptcy over an underwater mortgage depends on a number of circumstances. Request a consultation with a qualified bankruptcy attorney to fully understand your options.

Walk Away and Allow Foreclosure

Letting the lender foreclose on your home is one way to get out of an underwater mortgage, but it doesn’t provide any benefits compared with your other options. During foreclosure, the bank gains possession of your home and cancels your remaining mortgage debt. In some cases, the cancelled mortgage amount can count as taxable income.

If you allow foreclosure, you’ll end up with zero mortgage debt, but no home and a badly damaged credit score. Foreclosure can leave a negative mark on your credit report for up to seven years, which will make it difficult to qualify for a new home loan. A bad credit score can even hinder your ability to rent an apartment, so be sure you have a contingency plan for your living arrangements if you allow foreclosure.

Dealing with an underwater mortgage can be daunting, but it doesn’t have to end in foreclosure. If you’re unable to keep up with your upside-down mortgage, reach out to a certified credit counselor to explore your options. Your initial credit counseling consultation is typically free, but additional services like debt management plans may come at a cost.

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