Underwater mortgages occur when a homeowner owes more on their property than its current market value, often due to refinancing or changes in property values. This can lead to foreclosure if the homeowner cannot keep up with mortgage payments.
Underwater mortgages are mortgage deals that effectively leave the homeowner with more debt on the property than the current market value. In general, an underwater mortgage situation does not arise when a buyer obtains a first mortgage. The condition tends to arise when a second or third mortgage is taken out, or if factors within the area cause the property to depreciate unexpectedly.
One of the most common ways to get into an underwater mortgage situation is when a property owner chooses to refinance an existing mortgage. Lenders may offer the option of borrowing the existing equity in the property. In some cases, this may be a viable option, assuming a large amount of capital is accumulated. However, if the amount of equity is relatively small, this solution can quickly lead to a level of debt on the property that exceeds the current market value. When this occurs, the property owner is essentially in an underwater mortgage situation.
Another common way mortgages take on an underwater look is changes in property values. When rezoning or other changes are made to the area, there is a chance that the property’s market value will drop below the total current outstanding mortgages. This essentially creates a situation where the owner would not be able to sell the property to earn enough income to pay off all of the current debt.
In some cases, an underwater foreclosure situation occurs because the owner chooses to overextend loans against the property. For example, there are many lenders who will extend a third mortgage based on the applicant’s credit history and job security. However, if the homeowner loses their job and cannot keep up with all outstanding mortgage payments, the third mortgage effectively puts the homeowner’s finances under water.
A real estate crisis can also create an underwater foreclosure situation. When there is a demand for living space that exceeds the number of units available in the area, the prices of any given home will increase significantly. The end result is that market values temporarily rise and mortgages are taken out to meet current prices. When the crisis ends and market values fall, homeowners owe more on their homes than the property is actually worth. At this point, the owner will find it virtually impossible to sell the property for enough to cover the cost of the mortgage, and they are more likely to default.
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