What to do when you're underwater on your mortgage.
Eddie would like to to sell his home, but like millions of Americans, the widely touted housing recovery hasn’t fully reached his North Akron, Ohio, neighborhood. He owes about $60,000 on his mortgage and the two experienced real estate agents he consulted put the value of his home at somewhere around $58,000 to $59,000. Even if he were to find a buyer who would pay the full $60,000 he owes, by the time he paid a real estate commission and closing costs, he would have to bring a few grand to the table.
“Being underwater on the mortgage has me trapped here,” he writes in an email. “As I sit here right now, I cannot even sell my home without taking a loss, and that will prevent me from buying the next house.”
Eddie’s not alone. According to CoreLogic, at the end of 2014, 10 million (20%) of the 49.9 million residential properties with a mortgage have less than 20% equity (referred to as “under-equitied”) and 1.4 million of those have less than 5% equity (referred to as near-negative equity). According to the Zillow Negative Equity Report, “the rate of underwater homeowners was much higher among the homes with the least value.”
What can borrowers who find themselves with little or no equity to do? Here are six options.
1. Cough Up Cash
Coming up with cash to get out of an unaffordable home may make sense if it will save money in the long run. Run a “break even” analysis to find out at what point your monthly savings will exceed the money you must pay to get out. For example, let’s say Eddie would have to come to the closing table with $5,000 to get out of his current home loan. If he saves $100 a month in a different home it will take him 50 months to replenish his savings with the money he paid at closing. After that, his $100 a month savings is money in his pocket. But if he’d save $300 a month on a new home, it would take less than two years to come out ahead. (Of course, that’s a simplistic example that doesn’t take into account taxes, the cost of moving or buying a new home, etc.)
In order to reduce the money they have to pay to get out of their homes, some borrowers are opting to sell their homes themselves to save money on real estate commissions. (Ever wonder why real estate commissions are often 6% of the sales price?) This may be an option for a seller who is comfortable doing most of the work themselves and in no rush. Be sure to factor in closing costs as well. Some may be negotiable, but some won’t be.
2. Let It Go
At some point, it may make sense for a borrower to cut their losses and move on, whether that involves deed-in-lieu of foreclosure, a short sale, a bankruptcy or a combination of those.
In Eddie’s case, he has a very good reason to avoid this route. Over the past two years he’s been diligent about rebuilding his credit scores and has made significant progress, raising his credit scores anywhere from 75 to 100 points or more, depending on which credit scoring model is being used. (You can get your credit scores for free on Credit.com to see where you stand and to track your credit-building progress.)
“He’s worked so hard to improve his credit score I wouldn’t want to recommend anything that would take him in the wrong direction,” says Credit.com contributor Charles Phelan, founder of SecondMortgageAdvice.com. For example, if he stops making his mortgage payments in order to get his lender to agree to a short sale it would cause significant damage to his credit scores. Since he’s not in distress, it probably wouldn’t make sense.
For those who do think it’s time to let go, however, it’s a good idea to get professional advice as there may be both legal and tax implications to walking away from your home. Here’s a complete guide to your options if you are underwater on your home.
And there’s another option that might work: “If a seller can prove that he or she has buyer – as evidenced by an executed purchase contract with a meaningful earnest money deposit in escrow – the seller can use that as leverage to haircut the loan just enough to make the deal close. But just calling the bank and asking them without anything in writing and earnest money won’t do anything,” says Salvatore M. Buscemi, author of Making the Yield: Real Estate Hard Money Lending Uncovered. And if the lender won’t budge, “the buyer isn’t obligated to cover any shortfalls for the seller,” he warns.
3. Pay Down Debt
Paying down the principal balance on your mortgage can get you to positive equity faster. Eddie says he has taken a part-time job to bring in extra cash to do just that.
A word of caution: homeowners need to be careful not to become “house poor” by sinking all their their money into their home, and failing to leave cash available for emergencies. If that happens, it’s easy to end up in a situation where they are forced to run up credit card debt to fill in the gaps.
4. Raise the Price
Increase your home’s value and you may be able to get a higher price. “I began a renovation that will encompass the kitchen (refinishing cabinets, new range hood, new lighting, fresh paint and laminate flooring) the bathroom (a tub surround, a shower door and a new floor), and the living room (these awful white walls will soon be tan),” Eddie says. “Hopefully once these renovations are complete I will see my home value increase by at least $5,000.”
“Cosmetic improvements or little incremental improvements can start to bump the value up,” says Phelan, “because he’s not that far away from having property that’s coming back in the money.” Just be careful to focus on improvements that are likely to increase the home’s value. Be especially careful about going into debt here. If the home doesn’t sell, you’re stuck with that extra monthly payment.
Eddie’s decided it’s worth a try. “Worst case, I will have a house with three rooms renovated,” he says.
5. Rent or Be a Renter
For those who can swing it, another option may be to go ahead and purchase another home now, says Scott Sheldon, senior loan officer with Sonoma County Mortgages and a Credit.com contributor. “If you purchase the new property as an investment property you can use the projected fair market rents to purchase the property to offset the mortgage payment, typically at 75% of the gross rents.”
In other words, purchase the new home as a rental and move into it later. “He is going to be paying a premium, a higher interest rate and higher fees, to purchase the property as an investment property,” he warns. For some, though, this could be a way to snag a property at an attractive price and then move into it later.
What about renting out his current home and purchasing the other as his primary residence? “In order to convert a primary home to a rental property you have to have 30% equity in the property supported with fair market appraisal and have a tenant lined up by closing,” says Sheldon. “This way you can use the fair market rents to offset the mortgage payment of your current home, allowing you to go buy another one.”
Since Eddie is nowhere near that level of equity yet, that option is off the table for the moment. For someone considering this path, remember that becoming a landlord can be quite risky. If your tenant doesn’t pay rent or trashes your property, your costs can mount quickly.
6. Wait It Out
Finally, if none of these strategies work, simply continuing to pay the mortgage and live in the home may be the best option. However, if Eddie stays, both Sheldon and Phelan suggest he look into whether he can refinance his current loan through the Home Affordable Refinance Program (HARP). If he brings his interest rate and payment down, he’ll be able to throw more money at the principal balance. Phelan also encourages him to contact a local housing agency for a free consultation. There may be local programs that could help.