6 Options if You're Underwater on Your Mortgage
Of all the changes you might make to live more cheaply, the most fundamental is finding a cheaper place to live. Sadly, it's an option that's largely closed to people who are underwater on their mortgages. Unless they have cash to cover the difference between what their house will sell for and what they owe, they're pretty much stuck. Here are six options for people in that situation. (See also: How to Check if Your Mortgage Statement is Correct)
Except for option No. 1, you'll definitely want to get legal advice well in advance of actually doing any of these. Situations differ and the rules are different in different states. In particular, the option to just "walk away" from a mortgage is not available in every state! There are tax consequences to doing that, and to several of the other possibilities. A consultation with a lawyer could save you tens of thousands of dollars.
With that proviso, here are the options I could come up with:
1. Suck it up.
If your house still serves as shelter and you can still afford it, there's no particular reason that you can't just go on living in it, pretty much without regard to its value versus what you owe on the mortgage.
This may be the most expensive option: You can't take advantage of the cost savings of moving to a cheaper place, plus you're putting significant amounts of capital into an investment that might never give you a good return. Still, as long as you can make the payments, this is probably the default option, and it's not necessarily a bad one. Eventually — no matter what happens to the real estate market — you'll be above water on the mortgage. (In fact, eventually you'll pay off the mortgage and own the house free and clear.)
2. Rent it out.
If you can rent the house for enough to cover the expenses of ownership, then you can move into a less expensive place and live there. In fact, even if the rent doesn't quite cover the costs, you can still come out ahead if you can find a place to live that's cheaper (and reliable tenants).
Less drastic than that, you could rent out a room. That could make staying in the house as economical as moving someplace cheaper. In fact, there's no need to stop at renting out just one room — if you have a big house, you could potentially rent out two or three. At the far extreme, you could move into the basement and then rent out the whole rest of the house to another family. Not what you had in mind when you bought it, but perhaps better than losing the place to foreclosure.
3. Short sale.
This is where you get the bank's permission to sell the house for less than the balance due on the mortgage. Sometimes the bank will settle for the sale price and wipe out the debt. Other times they still expect you to pay part or even all of the difference — the balance due is just converted into an unsecured loan. Even in the latter case, you at least owe a lot less money. (Of course, you also have no place to live.)
This is one case where you really have to check with a lawyer. If the bank forgives any of the loan, the IRS may treat that amount as taxable income.
4. Renegotiate the mortgage.
This covers a lot of ground. If your lender agrees, pretty much all the terms of your mortgage are negotiable — the interest rate, the number of payments, even the balance due.
The federal government is pushing several different plans to adjust the terms on mortgages to make them affordable. One that I've read about involves moving the rate down to market rates and then adjusting the balance down to no more than 85% of the house's current value. That might make the house affordable to keep. It might just make it affordable to sell.
If there was a temporary problem in making payments (due to something like illness or unemployment) that has now been solved, it may be possible to roll all the missed payments into the balance and start fresh.
5. Walk away.
In some places, mortgages are often made on a non-recourse basis — that is, the bank can take your house, but can't come after you for any balance due on your mortgage. (Check with a lawyer! This is not true everywhere — and even places where it is often true it isn't always true.)
Often better than literally just walking away is to negotiate what's called a deed-in-lieu, where the bank agrees to take the deed and forgive the balance owed on the mortgage.
The way to do this is to:
- Offer the bank a deed-in-lieu.
- Stop making payments.
- Continue to live in the house.
This gives you a certain amount of leverage, because taking your offer saves the bank the trouble of foreclosing (and the risk that you'll trash the house the day before they foreclose). It also (since you're living rent-free until the bank ether agrees or forecloses) gives you a chance to save up some money. (Save it in a different bank!) That's going to be important: You're going to need it to find another place to live, and your access to credit is going to be limited for quite some time if you try this option.
Especially if a lot of your assets are in retirement plans (which you generally get to keep), bankruptcy is one option for households with an untenable cost structure.
Yet again, check with a lawyer. There are certain things that you get to keep in a bankruptcy, but they vary from state to state. Making the right moves before a bankruptcy filing can save you thousands of dollars. For example, the tools of your trade are usually protected, so you wouldn't want to sell them before the bankruptcy filing — you'd be turning a protected asset into something that's up for grabs.
Those are the options that I can think of, for people who are underwater on their mortgage, but who would like to consider the option of cutting their expenses by living someplace cheaper. Maybe one or another will turn out to be the right move for you.