If your mortgage balance exceeds the current value of your home, you’re dealing with what’s referred to as an underwater or upside-down mortgage. This situation typically arises when property values decline or when homeowners accumulate excessive debt, often a combination of both factors.

Having an underwater mortgage can be concerning as it complicates selling your property and limits options like using it as collateral for loans. If you’re considering refinancing to alleviate this situation, it’s not a straightforward process, but there are avenues to explore. Let’s delve into what underwater mortgages entail, how to determine if you’re in this situation, and the available options for refinancing underwater mortgages.

Refinancing an underwater mortgage poses challenges because it lacks home equity, a key requirement for most banks when issuing home loans.

According to Peter Palion, a certified financial planner from East Norwich, New York, “Banks usually seek to secure their interests with a certain level of home equity, making refinancing an underwater mortgage generally not feasible. However, renegotiating the terms of the existing loan might be an option.”

Despite these obstacles, refinancing may still be possible. Here are the steps to consider:

Determining if your mortgage is underwater involves comparing the amount you owe on your mortgage with the current market value of your property. Review your amortization schedule received at closing to pinpoint how many payments you’ve made or the loan’s date, which indicates the outstanding balance. To estimate your property’s current value initially, seek an estimate from a local broker. A formal appraisal will eventually be necessary.

Once you confirm your mortgage is underwater, promptly contact your lender. Even if you’re uncertain or overwhelmed, it’s crucial to inform your lender about the situation and discuss potential solutions. Request to speak with someone familiar with handling “problem loans” and gather information on available options. Document all communications for future reference.

While refinancing an underwater mortgage presents challenges due to the lack of equity, there are options available for qualified borrowers. Some lenders offer refinancing for conventional loans despite this limitation, and more options exist for government-backed loans.

There are specialized refinance programs tailored to assist homeowners in this situation, particularly those with government loans.

If you currently hold a Federal Housing Administration (FHA) loan, opting for an FHA Streamline refinance might be advantageous. The term “Streamline” indicates that the process involves minimal documentation and underwriting by the lender. Notably, FHA Streamline refinances do not necessitate a home appraisal, simplifying the refinancing process for homeowners with underwater mortgages.

Key requirements include:

  • Having an existing FHA mortgage
  • Ensuring that the mortgage you intend to refinance is up to date

The United States Department of Agriculture (USDA) provides a streamline assist refinance option that can be beneficial for refinancing underwater mortgages. Current USDA direct or guaranteed home loan borrowers may qualify for this refinance loan, which offers:

  • Low or no equity requirements
  • No home appraisal or inspection necessary (unless you received a subsidy as a direct borrower)
  • No credit review
  • No evaluations of debt-to-income ratio

Since not all mortgage lenders offer USDA loans, it’s advisable to compare different lenders to find one offering competitive interest rates.

Key requirements include:

  • Having a current USDA loan
  • Being current on loan payments for at least 12 months before refinancing
  • Income must not exceed the adjusted annual income cap for your county or metropolitan statistical area

If you have a loan backed by the Department of Veterans Affairs (VA), you may be eligible for a VA streamline refinance, also known as an Interest Rate Reduction Refinance Loan (IRRRL). Similar to USDA and FHA streamline loans, the VA streamline refinance is designed for borrowers looking to reduce their monthly payments by securing a lower interest rate, switching from a variable-rate to a fixed-rate loan, or both. To qualify for this option, you must:

  • Currently hold a VA-backed loan
  • Use the IRRRL to refinance your existing loan
  • Currently reside in or have previously lived in the home associated with the loan

While each program has specific requirements, there are steps you can take to improve your chances of qualifying. One crucial step is to maintain current on your mortgage and other debt payments. Most programs mandate no late payments in the last six months and no more than one late payment in the previous 12 months. A history of timely mortgage payments enhances your application’s appeal for underwater mortgage programs.

Additionally, ensure your loan is seasoned before applying. Loan seasoning refers to the time elapsed since you obtained the loan. Some programs may require a seasoning period of 15 months to qualify for an underwater mortgage program, while others may accept as little as 12 months.

Refinancing an underwater mortgage poses challenges, but it can also offer several potential benefits:

  • Accelerated mortgage repayment: Refinancing may allow you to redirect savings from reduced monthly payments towards paying down your mortgage balance faster. Lower payments can result from either a decreased interest rate or a reduction in the principal balance on which interest is calculated.
  • Emerge from underwater status: While adjusting your mortgage payments won’t alter your home’s value on its own, more manageable payments may enable you to pay down your mortgage balance more quickly. Over time, this could lead to being no longer underwater.
  • Lower interest rates: Qualifying for a refinance program could potentially secure a better interest rate. However, this alone won’t change your underwater status unless you apply the savings towards paying down the principal.

Refinancing an underwater mortgage also has its drawbacks, including:

  • Costs involved: Like any home loan, refinancing typically incurs closing costs and other fees. These expenses can add up and should be factored into your decision.
  • Potential break-even challenges: If you sell your home shortly after refinancing, you may not recoup the money spent on the refinance process. It’s crucial to assess how long you plan to stay in your home and calculate the break-even point to determine if the refinancing costs are worthwhile. Typically, the break-even point is around five years, but it’s possible that home values could increase during this period, making the expense more beneficial.

You have the option to list your home on the market and negotiate with your lender to accept a sale price that is lower than the mortgage balance—a process known as a short sale. However, this cannot be done without the lender’s consent.

Short sales typically involve extensive paperwork and can take several months to complete. Despite the challenges, a short sale might be preferable to foreclosure if waiting for the bank to foreclose on your home is the only alternative.

While not an ideal situation, some homeowners with underwater mortgages opt to surrender their homes if they can no longer afford payments. This process, known as a deed in lieu of foreclosure, involves voluntarily transferring the property deed to the lender. Surrendering the property in this way typically has less impact on your credit score compared to foreclosure. It may also incentivize the lender to negotiate, as they generally prefer not to take ownership of the property.

If you’re aiming to regain equity, paying down your mortgage could be the most direct path forward, provided your budget permits it. This approach may not be necessary if you intend to stay in the home and can manage current payments comfortably. However, it could prove beneficial if you’re planning to sell the property soon or aiming to facilitate a smoother refinancing process in the future.

One possible solution for addressing an underwater mortgage is through a loan modification. Unlike a refinance, a mortgage modification adjusts the existing terms of your home loan. Your lender is not obligated to approve new terms, but if they agree to reduce your principal balance, it could potentially bring your loan closer to being in a positive equity position or at least improve the situation.

If you intend to stay in your home for the long term and can manage the mortgage payments comfortably, maintaining stability and continuing with your current situation may be a viable strategy. Being underwater typically does not significantly impact your daily life. Over time, there is potential for the property to regain its previous value, particularly if the initial decline was influenced by temporary economic factors or local real estate adjustments.

However, as financial planner Niv Persaud, managing director of Transition Planning & Guidance in Atlanta, points out, certain factors such as changes in local government, property taxes, school districts, nearby developments, and other market influences can potentially lead to a more enduring decline in property values. By conducting thorough research and understanding your neighborhood dynamics, you are better equipped to assess the market’s trajectory and determine whether the downturn is temporary or likely to persist.

If you’re contemplating refinancing an underwater mortgage, the initial step is to determine whether your mortgage meets the criteria for any underwater-refi programs or if your conventional lender permits it.

If refinancing isn’t currently an option, exploring alternatives such as requesting a short sale, seeking a mortgage modification, or diligently paying down the balance until you regain equity may be necessary.

Before taking any drastic actions, it’s crucial to understand the reasons behind the decline in your home’s market value. If it’s a broader economic or market trend affecting homes in your area, patience might be the wisest approach. Avoid turning a temporary decline on paper into a lasting financial setback.