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 cash to pay the loss out of pocket.
Explaining Underwater Loans
BREAKING DOWN Underwater Mortgage
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 value of the home 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 U.S. 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 effected 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. (See also: When Did the Real Estate Bubble Burst?)
Subsequently monetary policy implementation from the Federal Reserve helped the U.S. economy to recover and housing prices to rebound. Lower interest rates following the crisis also helped to reduce mortgage payment burdens and increase some demand for real estate.
Assessing Home Value
Given new market initiatives from the Dodd-Frank legislation helping to improve mortgage lending standards it is not likely 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 have the obligation to closely follow home values and mitigate underwater mortgage risks.
To maintain a good understanding of 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 a number of factors which may include national market trends, recent sales by similar properties in the region and neighborhood as well as 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. (See also: 6 Tips For Protecting Your Home's Value)