The Ultimate Guide to Underwater Mortgages

Written by Credit.com | Jul 20, 2011 12:00:03 PM

Feel like you are drowning under your mortgage? Millions of Americans are "underwater" on their home loan, meaning that they owe more than the home is worth. Here are six options for dealing with an upside down mortgage:

Option 1: Stay And Pay

If you can afford your payments, you may want to hang in there. But if you have little breathing room in your budget, or if your circumstances change, you may be at risk of defaulting in the future.

Key Questions:
Is budget so tight that you are at risk of defaulting if anything goes wrong? How long will it take to return to positive equity?

Tax Consequences: None
Credit Damage: None

Option 2: Refinance

Yes, you may be able to refinance an underwater home under the Home Affordable Refinance Program, provided the new first mortgage totals no more than 125% of the value of your home.

Key Questions:
Will the refi lower payments enough to make your home affordable, or put you in a stable loan long-term?

Tax Consequences: None
Credit Damage: None

Option 3: Loan Modification

Lenders may be willing to modify your loan to reduce the interest rate, extend the term or even reduce principal. But many borrowers report extreme frustration trying to get a loan mod approved. And successful loan modifications usually involve a reduction in the principal loan balance, but those are few and far between.

Key Questions:
Does modified loan offer a long-term solution or just a temporary fix?

Tax Consequences: May owe taxes if principal is reduced.
Credit Damage: May be severe but temporary since negative notations are often removed when modification becomes permanent.

Option 4: Short Sale

With a short sale, the lender agrees to let you sell your home for less than you owe. It's important to make sure you won't still owe a large balance (a "deficiency"). if you have a second mortgage, you'll need to negotiate a settlement on that loan too. Get a real estate agent and attorney to guide you through the process.

Key Questions:
Will you be responsible for a deficiency and/or taxes on the forgiven debt? If so, you may need to file for bankruptcy.

Tax Consequences: May owe taxes if principal is forgiven.
Credit Damage: Will likely be severe and equivalent to foreclosure.

Option 5: Walk Away / Foreclosure

If your efforts to save your home fail, or if you decide it's not worth it to stay in a deeply underwater home, you may go into foreclosure. In non-judicial states, foreclosures can happen quickly, while in judicial states, they can take months or years. In the meantime, homeowners may stay rent-free.

Key Questions:
After foreclosure, will you be responsible for a deficiency (common with recourse loans) or be able to truly walk away (non-recourse loans)?
Will you owe taxes?

Tax Consequences: May owe taxes if home is worth less than amount owed.
Credit Damage: Will likely be severe. If sued for a deficiency, the judgment can be reported separately.

Option 6: Bankruptcy

Bankruptcy won't reduce the amount owed on a first mortgage for your principal residence, but it may be used to eliminate an underwater second mortgage, catch up on payments on delinquent loan, and/or force lender to modify the loan. Can also be used in conjunction with foreclosure or short sale to eliminate deficiencies and/or tax liability.

Key Questions:
Can it help you reduce or eliminate an underwater home equity loan? Is the mortgage affordable in the long run or is it better to truly walk away and get a fresh start?

Tax Consequences: No taxes due on debts discharged in bankruptcy.
Credit Damage: Severe.

Special thanks to Credit.com team members Gerri Detweiler and Brad Jerger for their hard work in making this infographic possible.

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