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What to Do When You're Underwater on a Mortgage

Being underwater on a mortgage comes with some serious risks and limitations. Most people can escape this trap by avoiding new debts while continuing to make monthly payments.

Small model house on top of a pile of 1 dollar bills.

There's no question about it -- homeownership comes with significant benefits. It allows you to build equity over time, which helps you save for retirement. Mortgages also offer a variety of attractive tax advantages. Over the long term, buying is ultimately less expensive than renting, which makes it a sound financial choice for most people.

That is unless you fall into the debt trap. In the context of homeownership, this often occurs when you're "underwater" on a mortgage -- a term that means you currently owe more than the house is worth.

Let's take a deeper look at why this is such a problem, and what you can do to get your loan above water again,

The Perils of an Underwater Mortgage

Owing more than your home is worth is often a difficult situation to navigate. For one thing, it severely limits your flexibility. Being underwater on your loan can prevent you from selling your home, unless you're willing to make up the difference between the amount owed and the sale price out of pocket. Additionally, being underwater prevents a homeowner from refinancing in many cases - something that can have highly negative repercussions. 

If a homeowner can't afford to make payments because of a job loss or some other change in material conditions, refinancing is one standard option. Being underwater often takes this choice off the table, however, which may lead to foreclosure or other negative outcomes. 

How to Avoid Going Underwater

Those who end up owing more than their houses are worth often start down this path early in the process, either by opting for the wrong loan or choosing the wrong house. Finding a competitive interest rate is important -- today, 30-year fixed mortgages are generally available at between three to four-percent interest, even to borrowers who have credit scores below 700. Finding terms such as these -- and a fairly-priced home in good shape that's not in an overheated real estate market -- will help ensure you don't slip underwater.

A sizeable down payment is also important. While some FHA programs will allow you to qualify for a mortgage with as little as five-percent down, it's generally advisable to aim for between 15 and 20-percent down when possible. This also reduces the odds your loan will eclipse the value of your house.

What to Do if You're Underwater

If you're already struggling with a loan that outstrips the value of your home, there is no need to panic. If you keep making your payments on time, being underwater will likely be a temporary situation. Once you make up the difference, you'll be eligible for refinancing and other options. 

This means that making regular payments -- and even paying a bit extra every month - should be a priority. Once you're mortgage is no longer underwater, you regain crucial flexibility. You can sell your home or renegotiate your terms without any loan-imposed limits. 

Those who cannot meet their payments due to a job loss or similar financial setback should contact their lender immediately, and work toward a solution that prevents foreclosure.

The Takeaway

Being underwater on a mortgage comes with some serious risks and limitations. Most people can escape this trap by avoiding new debts while continuing to make monthly payments. Once the mortgage is back above water, borrowers have the freedom to renegotiate terms and sell without making up the difference out of pocket.