What Does Underwater Mean?
Underwater is the term for a financial contract or asset that is worth less than its notional value. This item could be an out-of-the-money call option where the stock currently trades above the option's strike price. More commonly though, the term is used in relation to a house, or another substantial asset, which has an outstanding mortgage or loan on the asset that is a larger amount than what the asset is worth.
In either case, the holder has an asset without intrinsic value. In the case of the mortgage or loan, the holder of the asset actually owes more than the asset is worth.
Underwater is also referred to as upsidedown.
- Underwater means an asset is out-of-the-money, an options trading term, but more commonly refers to having a loan on an asset that is larger than what the asset is worth.
- A homeowner is underwater if their mortgage is larger than what the home is worth.
- Underwater situations can often, but not always, be avoided by looking for good deals and creating a margin of safety between the asset's value and the loan amount.
Explaining Underwater Loans
In options trading, an out-of-the-money (OTM) call has a strike price above the current price of the underlying stock or commodity. An OTM put has a strike below the current price of the underlying. If the underlying asset cannot move above the call strike or below the put strike, the option will expire worthless. This occurs because all of the value of an OTM option is derived from its time value and the potential for the underlying to move in-the-money (ITM). However, if it doesn't move ITM, all of that time value decays, leaving the option holder with a worthless asset.
Traders use OTM options when they believe the underlying asset will eventually move in the desired direction.
More commonly, underwater means owning an asset that is worth less than an outstanding loan on that asset. This could happen in a margin trading account, where a trader owns a stock on leverage, but the company (stock) declares bankruptcy and the stock holdings no longer cover the margin or loan the broker provided to buy the stock initially. The account is underwater, and the investor will need to find funds somewhere else to pay back the money (loan) they lost in the stock market. This is called a margin call.
If a new car is purchased with a loan, the purchase almost immediately results in the buyer being underwater because the car will depreciate immediately once it is driven off the lot while the loan will be paid down slowly over years. Eventually, as more payments are made, and the car depreciates at a slower rate, the car will be back above water. For example, in 10 years the loan is paid off but the owner can probably sell the car for a few thousand dollars, depending on the make and health of the vehicle.
Underwater Real Estate
In real estate, underwater refers to the situation where a house or other property is worth less than the money owed on the loan. This poor value presents problems for both the homeowner and the holder of the mortgage. If the homeowner needs to move, the sale of the home will not produce sufficient monies to pay the mortgage holder, even before any transaction fees. In this case, the homeowner must find additional funds or enter into a short sale with a third party. These types of problems, in turn, lead to legal battles and possible difficulties down the road for both the original homeowner and the third party lender.
While a short sale does complicate the process by which the original lender recovers their money, a more significant problem with underwater mortgages emerged after the housing bubble in 2006 and bust in 2007. Homeowners owing more than their home's value quietly walked away from their investments. This resulted in mortgage defaults, leaving the lending banks with losses and the added expenses of liquidating their acquired homes.
Tips to Avoid Being Underwater
Being underwater on a loan isn't always a horrible thing. As long as payments are made, the loan is paid down and the underwater situation may end up being temporary. That said, underwater situations can be mostly avoided by looking for a margin of safety in regards to the asset being purchased and the loan amount.
Getting a good deal on a house or car, where the value of the asset could be sold for more than what is paid (given some time) will mean the loan amount is smaller and there is a larger buffer between the asset's value and the loan amount. This means the asset would need to fall in value more in order to be underwater. Compare that to a couple that overpays for a house, paying $300,000 in a bidding war for a house that is really only worth $280,000. Depending on how much they put down, they could be underwater immediately, or if housing prices fall they could be underwater substantially in a short amount of time.
Missing payments or incurring additional fees for violating the terms of the loan can increase the loan amount owing quickly. This can cause a loan to move underwater, or deeper underwater. Lenders are often willing to work out solutions with borrowers if the financial struggles are short-term, as the lender doesn't want to have to go through the struggle of selling an underwater asset to only partially pay back a loan at a loss.
If dealing with financial problems, talk to a financial planner, debt counselor, and/or the lender to help find a solution before the problem gets worse.
Example of Being Underwater on a Mortgage
Assume a person sees a house they like listed at $400,000. They have $40,000 for a downpayment, or 10%. Not including other fees and mortgage insurance, which will mean some of the downpayment won't be going to the principle, for simplicity assume that the buyer gets a loan for $360,000.
Using the mortgage and downpayment the buyer pays for the house. Several months after the purchase they notice similar houses in their area are selling for substantially less than $400,000. Similar homes, called comparables, are selling for $350,000. The loan value of $360,000 has only dropped incrementally to $359,000 as much of the initial payments go to interest and not principle, yet the house is only worth $350,000. If the house was sold, it could not pay off the loan. This is referred to as being underwater or upside down.
If the housing market stabilizes, eventually the loan will be paid down and the property loan will no longer be underwater. Being underwater a small amount, or for a short period of time, isn't a major issue. Being underwater for a long time and by a large amount indicates a poor purchase, poor timing, or poor market conditions. Possibly all three.
The house could be underwater for a number of reasons. Possibly the homebuyer overpaid in the first place. The house may have only been worth $350,000 all along, but the seller asked more and the buyer was willing to pay it.
Alternatively, the property value may have dropped. $400,000 may have been a good price at the time, but a recent downturn in the economy means fewer jobs and not as many people being able to afford their homes. Forced to sell, property values are driven down.
Property values often deteriorate slowly but can move quickly in certain areas. For example, a small town may see property values plummet very quickly if the main source of employment, say a plant or mine, closes. A certain street may see property values drop quickly if a gang takes of residence in one of the houses.