What is an Underwater Mortgage?
An underwater mortgage is a mortgage on a property that is worth less than what is owed on it.
How Does an Underwater Mortgage Work?
For example, let's say John Doe buys a house for $500,000. He makes a down payment on the house and borrows $400,000 to pay for the rest. Two years later, John loses his job and has to sell the house and move. However, the housing market has slipped in his town, and the house is only worth $300,000 right now. John owes $395,000 on the loan. He is underwater.
Even if he sells the house for $300,000, he would pay off only $300,000 of the loan and would still owe $95,000. Accordingly, if John were to sell the house for $300,000, he would need the bank to agree to write off the remaining $95,000. Thus, if John finds a buyer at $300,000, his lender would need to approve the sale and could even halt the sale if it believes that the house can be sold for more than $300,000. Every dollar below $395,000 is money lost to the lender.
Why Does an Underwater Mortgage Matter?
If a homeowner has to move right away, underwater mortgages can lead to short sales, which can be long and arduous. This is primarily because extra lenders are involved, and the bureaucracy of approving and processing a sale can scare off potential buyers who want to close on a house purchase quickly. However, buyers (that is, people who might want to buy John Doe's $300,000 house, in our example) can often get good deals on homes that have underwater mortgages, because lenders do not want to be in the business of owning real estate, want to be repaid as quickly as possible, and in our case, would rather have $300,000 than foreclose on the house.