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How to Refinance an Underwater Mortgage

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Of all the nightmare scenarios a homeowner can face, having an underwater mortgage is one of the biggest ones. When you’ve purchased an asset you expected to earn you equity and boost your net worth, watching the value drop is both concerning and disheartening.

You may have expected to use the equity you built to renovate the house so you could age in place — or perhaps you planned to sell the house in a few years and use the profits to fund your child’s college education. Realizing that these scenarios may no longer be viable options can seriously upend your financial strategies.

Fortunately, there are steps you can take to improve your circumstances even when your home loan is underwater.

What does it mean to be “underwater”?

A property is underwater when you owe more on the loan than the property is worth. Also referred to as having negative equity or being upside down on your mortgage, this situation typically happens when home values drop significantly, as was the case during the Great Recession. When the housing bubble burst, home values dropped and 50% of borrowers were suddenly underwater on their mortgages.

“There were a lot of clients caught up in the financial crisis where, as we well know, home values across the country reduced through no fault of the borrower, just the economic situation,” said Peggy Lawlor, mortgage products strategy executive at Bank of America. “When they bought their home, it might have been worth $200,000 or $300,000 and then as the years went on, it was worth a little bit less than that, and they ended up underwater — again, through no fault of their own.”

However, there are other circumstances that can lead to negative equity. Negative amortization — making monthly payments that are less than the monthly interest owed — can cause you to become underwater. Interest continues to accrue and you’re not making a dent in the principal, so you can find yourself owing more than your house is worth.

Borrowers can also become underwater by taking out multiple loans on a property. This situation usually involves fraud, with the borrower neglecting to tell a mortgage lender about the other loans, according to LendingTree Chief Economist Tendayi Kapfidze. When the total amount owed is greater than the property value, the homeowner is upside down on those debts.

Are underwater mortgages still a big risk for borrowers?

“We’ve seen a lot of improvement with the home price appreciation,” said Andy Walden, director of market research at Black Knight, a data analytics company. As of November 2017, Black Knight reported that were 1.36 million borrowers underwater in the U.S., representing just 2.7% of the homeowner population.

“That’s really the best look we’ve ever seen in the market from an equity standpoint, when we look at overall weighted averages for LTVs in the housing market,” Walden said.

ATTOM Data Solutions, another data analytics company, reported higher numbers of underwater properties recently, stating that negative equity properties were at 9.3% nationally as of the second quarter of 2018. However, ATTOM reports on total underwater mortgages, including commercial and residential properties, based on original loan amounts; Black Knight bases the numbers in their findings solely on single-family properties and current loan balances, which may explain the discrepancy. A third company, CoreLogic, reported numbers similar to Black Knight’s: 2.8 million residential mortgages underwater, as of September 2017.

Walden attributed the drop in underwater mortgages largely to the rise in home values. Available equity rose by more than $636 billion in the first half of 2018, representing a nearly-threefold increase since the bottom of the market in 2012. There were other factors as well, including borrowers being able to refinance or regain equity.

“Those borrowers that were underwater, they’ve been able to refinance or they’ve gotten modifications that improved their equity positions,” Walden said. “Or in a lot of cases, unfortunately, those borrowers have defaulted and kind of made their way out of the market. Those homes have sold to new borrowers who are back out from underwater on those homes.”

The chances of another scenario in which borrowers fall into underwater situations en masse are slim, Walden said. Home prices have been rising consistently, and he said they would need to drop significantly at the national level or in local markets for widespread negative equity to occur again. He said Black Knight hasn’t seen indicators of that happening, although home price appreciation has begun to slow in response to rising interest rates.

“As far as large-scale risks of a new wave of underwater borrowers, I don’t see anything looming in the market right now,” he said.

Malik S. Lee, CFP and founder and managing principal at Felton & Peel Wealth Management, agreed with Walden’s assessment. He said that lenders apply stringent enough criteria that borrowers are unlikely to get in over their heads financially, particularly given home prices have been rising and don’t appear to be cratering again in the near future.

When does it make sense to refinance an underwater mortgage?

Interest rates have been low for the past several years, making it a good time to refinance a higher-rate loan. But mortgages on underwater properties are typically difficult to refinance because you don’t have equity in the home. “Not a lot of lenders want to take on an obligation where the asset that backed the obligation is worth less than the obligation,” Kapfidze explained.

However, there are federal programs designed specifically to address the needs of borrowers who are underwater and want to refinance their loans or reduce their financial distress:

Home Affordable Refinance Program (HARP)

The government created the Home Affordable Refinance Program (HARP) to enable homeowners to refinance despite the lower values of their homes.

Not all upside down mortgages are eligible for HARP. Borrowers who have loans guaranteed by Fannie Mae or Freddie Mac and are current on their mortgage payments may be able to seek relief through the program if their mortgages originated on or before May 31, 2009. Borrowers may not have more than one late mortgage payment on their records within the previous 12 months. Additionally, borrowers’ loan-to-value (LTV) ratios must be 80 percent or higher.

Unlike traditional refinancing applications, HARP offers a faster, streamlined process because it does not require appraisals in many borrowers’ cases. This reduces the closing costs associated with the refinance, enabling homeowners to access the benefits that much faster.

The deadline for applying for HARP is Dec. 31, 2018.

Streamlined refinance programs

The government offers several other refinancing programs that help borrowers with certain mortgages get a lower interest rate and secure a fixed-rate loan.

These programs include FHA and USDA streamline refinance programs, in which borrowers with FHA- or USDA-backed mortgages can apply for refinancing without needing a home appraisal. These programs also allow borrowers to incorporate closing costs into their new loans rather than paying them up front.

Borrowers with VA loans may be eligible for interest rate reduction refinance loans (IRRRL). As with the FHA and USDA programs, IRRRL do not require appraisals and the associated fees and costs can be bundled into the new loan.

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What if I can’t refinance?

If you’re not eligible to refinance, there are other ways to ease a negative equity situation. Although an upside down mortgage detracts from your net worth, you may decide to simply continue paying your monthly payments as is until the market shifts in your favor. Should home values in your area go up again, the situation may right itself on its own.

“Don’t assume because you were underwater a year or two ago that you’re still underwater, because the value of the house may have gone up,” Kapfidze said. “One way to get out from underwater is to just wait it out.”

Lee said it’s worth speaking with a real estate agent who understands the projected trajectory of your area. Neighborhoods that expect to see new stadiums built nearby or other big investments in the near future may see home values rise again, alleviating the negative equity problem.

But if home values are not rising and you’re not eligible for refinancing, you still have options, though some are admittedly better than others:

Pay down the loan balance

Not all borrowers who are underwater experience financial distress, and if you have disposable income, you may want to aggressively repay the loan until you’ve brought down the balance. Making extra mortgage payments can help you right the loan more quickly, reducing your debts and growing your equity, Kapfidze said.

Sell the house

If your mortgage is underwater and you don’t want to stay in the house long-term or age in place there, you might consider putting the house on the market to see what you can get for it.

Ideally, you would wait to sell until your local market improves. However, if you need to move sooner and have other assets to sell, you can use those to pay off the difference between your mortgage balance and the proceeds of the sale, according to Lawlor. You do not need your lender’s permission to sell in this case, as long as you will repay the full amount owed.

Conduct a short sale

If you do not have additional sellable assets, another option for dealing with an underwater loan is to do a short sale. You will need to negotiate the terms of the sale with your lender, and you’ll sell the house for less than the value of the loan.

Lawlor gave the example of a borrower who has a $200,000 mortgage but only gets $175,000 for it in a short sale. Unless they have other assets they can use to cover the remaining $25,000 gap, the lender will have to charge off the loan at a loss and the borrower’s credit score will take a significant hit.

“It’s a distress situation. It’s nothing that you would want to do unless you really had to,” Lawlor said.

The lender may be able to pursue the remaining amount by garnishing your wages or using other methods to settle the debt. They may also agree to discharge the remaining balance on the loan, in which case you could be responsible for paying income taxes on that amount. It’s important to understand your exact responsibilities based on your mortgage contract before you decide to do a short sale.

Modify your mortgage

In cases of financial distress, in which borrowers are both underwater and unable to make their mortgage payments, lenders may be able to modify the terms or payment amounts to help them avoid delinquency.

According to Lawlor, this is especially true when the hardship is temporary. Someone who has been laid off but is actively looking for work will likely be able to resume their normal payments in six months to a year, and lenders can work with them to find a solution in the meantime.

Should you find yourself unable to make your mortgage payments, it’s best to talk to your lender sooner rather than later.

“The lender many times would rather you not get into a situation where you end up defaulting on the loan,” Kapfidze said. “They can be very willing to work with borrowers who take the initiative to contact the lender before they get into real trouble. The lender might actually help you get out from being underwater.”

Agree to a deed in lieu of foreclosure

A deed in lieu of foreclosure is effectively the same as simply walking away from your home and defaulting on the mortgage, Lawlor said.

“You’re basically turning over the deed to your home to the lender because you’re in financial distress — possibly due to illness, possibly unemployment — and you simply can’t make the payments anymore,” Lawlor said. “It’s a sad situation some folks will find themselves in, and customers should really talk with their lenders and find out what’s the best solution.”

Once you’ve relinquished ownership, the bank will then sell the home, and your credit will take a significant hit. Lawlor said it’s unlikely that a borrower who had done a deed in lieu of foreclosure would be able to buy major assets such as another house or a car on credit for some time following the deal.

“It would only be advisable if the client has no other option,” she said.

Can you underwater-proof your mortgage?

Because mortgages can go upside down based on changing housing values, it may seem that borrowers have little control over whether this will happen to them. However, there are ways you can protect yourself.

Current homeowners can mitigate their risks of going underwater by paying more on their mortgages when possible, Lawlor said. If you’re able to put a bonus or commission check toward making an extra mortgage payment for the year, you can create a financial buffer for yourself in the event that house prices go down.

For first-time home borrowers, Lawlor said that having a larger down payment can help insulate you from big valuation swings, as can buying a smaller house to avoid maxing out your borrowing potential. The lower your loan-to-value ratio, the safer you are from an underwater scenario.

Lawlor also recommended borrowers understand the market conditions in their areas. Pay attention to news stories about the real estate market and the economic climate. When home values are inflated, buyers are paying above asking price on houses, and if there are rumors of a housing bubble, you’ll want to be very cautious about your decision to buy. Lawlor said it may be prudent to continue renting until the market stabilizes because those indicators increase the chances of negative equity scenarios.

“Those potential housing bubble situations are the ones that, if there is a financial downturn in the next year or two, those are the situations where a borrower could find themselves underwater,” Lawlor said.

Take action

You’ll need to consider your options carefully when responding to an underwater mortgage. Before making a decision, it’s a good idea to talk with your lender so you can understand the pros and cons of each possible avenue. They may know of refinancing programs for which you’ll qualify, and they’ll be able to advise you on strategies for avoiding default. In the event that you need to do a short sale or deed in lieu of foreclosure, you’ll need to work with them on those, but the ideal is that they can help you long before it gets to that point.

If you see that home values are rising and believe you’ll benefit, doing nothing may be the best course. But even then, you’ll want to speak with real estate and lending experts who can inform that decision.

Whatever you choose, educating yourself and taking action are important. An underwater mortgage is distressing, but you’ll be helping yourself by taking some steps toward rectifying it, rather than looking away and hoping for the best.


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