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What is an underwater mortgage?

An underwater mortgage, sometimes called an upside-down mortgage, is a home loan with a higher principal than the home is worth. This happens when property values fall but you still need to repay the original balance of your loan. Mortgages aren't the only loans that can end up underwater.

rocketmortgage.com - Do You Have An Underwater Mortgage? Here Are Your Options

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There are two main ways that mortgages end up underwater: Decrease in property value or missed payments.

Let’s take a closer look at how this can happen.

Decrease In Property Value

Say you plan to buy a home for around $200,000. The bank orders an appraisal and the appraiser determines the home is worth $200,000. Satisfied, the bank gives you a loan for $160,000 because you put down $40,000 as a down payment. A couple years later, you notice that your neighbors are having trouble selling their homes. While the average property value in your area was $200,000 when you bought the home, homeowners in the area have lowered their selling prices to meet the lack of demand. Now, thanks to a decrease in property values, your home is only worth $120,000 and you still owe $155,000 on your mortgage.

Missed Payments

Your mortgage can also go underwater when you miss your mortgage payments. Let’s look at how that might happen. When you start making payments on your loan, most of the money you pay goes toward interest. As you begin to chip away at your principal loan balance, you pay less and less in interest. This process is called amortization. If you fail to pay off your interest one month, that interest will accumulate. Compounding interest makes it difficult to pay back your loan and may also put you underwater. Let’s say you borrow $130,000 to buy a home at 4% APR with a 30-year term. On your first payment due date, you owe $620.64. A total of $187.31 goes toward reducing your principal balance and the remaining $433.33 pays off the interest your loan accumulated since you took it out. Missing your payment means that the additional amount will also accumulate interest at 4% APR. You’ll go further underwater if you don’t make a payment equal to two monthly payments the very next month. This is why it’s so important to make sure you don’t buy a home you can’t afford.

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