Why is being "upside down" on a mortgage so bad?

Question

For the longest time (especially during/after the housing crash in the US), people would speak in hushed whispers or terrified pleas when they talked about being upside down on their mortgage. While I understand that an asset suddenly losing a huge chunk of its value is an upsetting event, I don't see why owing more on a mortgage than a home is worth is so specifically feared.

After all, that's standard practice for common loans like car loans ("gap" insurance exists because car loans are so frequently underwater) and student loans (by their very nature are 100% unsecured). Plus, these types of assets are inherently even riskier than home loans: the chances of accidentally destroying your car are substantially more than destroying your house, and student loans can literally never be escaped from.

Finally, home loans are extended over extremely long periods (i.e. 15 or 30 years), making any fluctuations in their value short-lived - even less reason to be obsessed over their current value relative to the loan.

Is there some legal issue with being underwater on a mortgage that would make this scarier than other types of loans? Is this a reaction to the common misconception that homes have a great return-on-investment? What specific reason makes underwater home loans so scary?

Answer 1

I can think of a few reasons why they seem like a bigger deal to people than similar situations with other loans.

1. Mortgage values are a lot larger than car loans. For many people, real estate is by far their largest investment. Being underwater on your car represents relatively few dollars by comparison. Student loans can potentially be scarier, but how do you know if your education is underwater?
2. People often have a belief that home values appreciate. This is perpetuated by realtors and by a market that did appreciate for a long time. For this reason having a home underwater was unexpected and therefore scary.
3. Mortgages underwater were part of a widespread economic problem. In some sense people in this situation could feel like they were victims of a whole system breaking down, rather than just bad luck on a single investment.
4. Being underwater on a home loan can impact your freedom to do things like move in order to take another job or even move out of your house and live with your parents again. When your home is significantly underwater you can feel stuck in a way that you don't feel when other loans are under water.

As you point out, though, being underwater on your home loan is a less serious condition than having large student loans and a poor paying job, for example. If the student loan situation ever comes to a head, we may have people talking about student loans in hushed tones.

Answer 2

The problem comes when the borrower cannot afford his home.

If a borrower buys more home than they can afford, as long as he can sell the house for more than he owes, he's not in a disastrous situation. He can sell the house, pay off the mortgage, and choose more affordable housing instead.

If he is upside-down on his home, he doesn't have that option. He's stuck in his home. If he sells it, he will have to come up with extra money to pay off the mortgage (which he doesn't have, because he is in a home he can't afford).

It used to be commonplace for banks to issue mortgages for 100% of the value of the home. As long as the home keeps appreciating, everybody is happy. But if the house drops in value and the homeowner finds himself unable to make house payments, both the homeowner and the bank are at risk. Recent regulations in the U.S. have made no-down-payment mortgages less common.

Answer 3

Here's a real-life example of why being underwater can be a tad annoying:

1. You purchase a condo for $150K and live there.
2. 5 years later you get married and your spouse wants to move in with you.
3. Your condo association does not allow dogs larger than 10 pounds. Your spouse has a 11 year old white shephard/wolfhound mix that weighs 105 pounds. Your spouse does not want to part with the dog. You do not want to part with your spouse.
4. You move out of the condo.
5. Due to the housing crisis, today your condo is worth $75K and you are $50K underwater. If you sell the condo, you have to come up with $50K immediately. Alternatively, you can short sale or foreclose, but this will hurt your credit, which you do not want to do.
6. You decide to rent out your condo, but your condo association does not allow renting.

Your options are:

• Continue to pay your mortgage, taxes, dues, and insurance for a condo that no one lives in.
• Come up with $50K cash and sell your condo.
• Short sale or foreclose and kill your credit for a few years.

You must choose one.

Answer 4

tl;dr: when everything is going great, it's not really a problem. It's when things change that it's a problem.

Finally, home loans are extended over extremely long periods (i.e. 15 or 30 years), making any fluctuations in their value short-lived - even less reason to be obsessed over their current value relative to the loan.

Your post is based on the assumption that you never move. In that case, you are correct - being underwater on a mortgage is not a problem. The market value of your house matters little, except if you sell it or it gets reassessed.

The primary problem arises if you want to sell. There are a variety of reasons you might be required to move:

• Job change (losing job, new job in different area)
• Family change
• Cannot afford mortgage payment
• Illness/disability

In all of these scenarios it is a major problem if you cannot sell. Your options generally are:

• Foreclose/short sale
• Own a home which is not actually being used
• Have enough cash to cover the difference

In the first option, you will destroy your credit. This may or may not be a problem. The second is a major inconvenience. The third is ideal, but often people in this situation have money related problems.

Student loans can deferred if needed. Mortgages cannot. A car is more likely to be a lower payment as well as a lower amount underwater.

Generally, the problem comes when people buy a mortgage assuming certain things - whether that's appreciation, income stability/growth, etc. When these change they run into these problems and that is exactly a moment where being underwater is a problem.

Answer 5

For most people "home ownership" is a long term lifestyle strategy (i.e. the intention is to own a home for several decades, regardless of how many times one particular house might be "swapped" for a different one.

In an economic environment with steady monetary inflation, taking out a long-term loan backed by a tangible non-depreciating "permanent" asset (e.g. real estate) is in practice a form of investing not borrowing, because over time the monetary value of the asset will increase in line with inflation, but the size of the loan remains constant in money terms.

That strategy was always at risk in the short term because of temporary falls in house prices, but long-term inflation running at say 5% per year would cancel out even a 20% fall in house prices in 4 years. Downturns in the economy were often correlated with rises in the inflation rate, which fixed the short-term problem even faster.

Car and student loans are an essentially different financial proposition, because you know from the start that the asset will not retain its value (unless you are "investing in a vintage car" rather than "buying a means of personal transportation", a new car will lose most of its monetary value within say 5 years) or there is no tangible asset at all (e.g. taking out a student loan, paying for a vacation trip by credit card, etc).

The "scariness" over home loans was the widespread realization that the rules of the game had been changed permanently, by the combination of an economic downturn plus national (or even international) financial policies designed to enforce low inflation rates - with the consequence that "being underwater" had been changed from a short term problem to a long-term one.

Answer 6

The largest problem and source of anxiety / ruin for homeowners during the housing market collapse was caused by the inability to refinance.

Many people had bought homes which they were stretched to afford, by using variable-rate mortgages. These would typically offer a very attractive initial rate, with an annual cap on the potential increase of rate. Many of these people intended to refinance their variable-rate to a fixed rate once terms were more favorable. If their house won't appraise for the value needed to obtain a new loan, they are stuck in their current contract with potentially unfavorable rates in the later years (9.9% above prime was not unheard of.)

Also, many people, especially those in areas of high inflation in the housing market, used a financial device known as a Balloon Mortgage, which essentially forced you to get a new loan after some number of years (2, 5, 10) when the entire note became due. Some of those loans offered payments less than Principal + Interest!

So, say you move near Los Angeles and can't afford the $1.2M for the 3-bedroom ranch in which you wish to live. You might work out a deal with your mortgage broker/banker in which you agree contractually to only pay $500/month, with a balloon payment of $1.4M due in 5 years, which seemed like a good deal since you (and everyone else,) actually expect the house to be 'worth' $1.5M in 5 years.

This type of thing was done all the time back in the day.

Now, imagine the housing bubble bursts and your $1.2M home is suddenly only valued at, perhaps, $750k. You still owe $1.4M sometime in the next several years (maybe very soon, depending on timing,) and can only get approved financing for the current $750k value -- so you're basically anticipating becoming homeless and bankrupt within the same year.

That is a source of much anxiety about being upside-down on a loan.

See this question for an unfortunate example.

Answer 7

Sample Numbers: Owe $100k on house. House (after 'crash') valued at: $50K. Reason for consternation: What rational person pays $100k for property that is only worth half that amount?

True Story: My neighbor paid almost $250K (a quarter-of-a-million dollars - think about that..) for a house that when he walked (ran!) away from it was sold by the bank for $88K. Unless he declares bankruptcy (and forgoes all his other assets, including retirement savings) he still owes the bank the difference.

And even with bankruptcy, he may still owe the bank - this should cause anyone to be a bit concerned about being up-side down in a mortgage loan.

Answer 8

Being underwater a little is not all that scary, but those who talk of being underwater are typically underwater by quite a lot. The amount of money they owe is large compared to their yearly income.

Consider a metaphor. I put you in a hole. Its only 1 foot deep. You're not too concerned. If you want to leave, you can step out of it. Now we look at a deeper hole, 3 feet. Now you're still not too concerned. You can't just walk out, but if you need to get out you can wiggle your way up. 6 feet. Now you start getting nervous. Climbing out is getting trickier and trickier. You may not be able to move in response to a changing enviornment around you, because you're stuck in a hole.

Now make the hole 10 feet. Now you can't reach the edges. Now you're in trouble. You have lost all mobility. You can't get out under your own power. Now if something bad happens (such as losing your job or a sudden health issue), you can't move around to solve the problem.

This is the issue that arise from underwater mortgages. Say you lose your job because the job market in your area dried up (think Detroit in the big auto manufacturer crash). You need to move. You are legally endebted to a lender for your existing underwater house by more than you can sell it for. You need to pay for the privilege to sell it. You still owe payments on it, so if you just buy a new house (or rent) in the new state, you're paying for twice as much property. You can't just shuffle the underwaterness from your old house to your new house because the new lender has no interest in giving a loan for more than the value of the new home.

The only options you have to play with is renting the old house, which many underwater families did, or bankrupcy. If the area you were in is depressed, you may not be able to rent the house for enough to cover your mortgage. This is the fear of being underwater. You have a piece of paper which claims some lender can take money from you that you may or may not have, and that the US government will allow them to take your assets, if need be, to settle the score.

If you're underwater by a few thousand, it's typically not a big deal. If you're underwater by 80 or 90 thousand dollars, which some people were, that's a lot of money to be endebted for without the assets to recover them.

If you subscribe to the realtor story that the market will recover, all you have to do is scrape by, holding on, until the market rises again. However, those who are underwater recognize that the reason much of this occurred is that we entered a bubble because realtors kept saying the market could only go up. Fool me once....

Answer 9

And then there is the issue of people who actually don't intend to reduce the size of their loan. They only want to pay the interest, so their debt with the bank remains constant.

If you are upside down, it means you will not have the financial means to remove the debt. If, for some reason, you are no longer able to pay the bank, you might lose the house. After that you will have no house, but you still have a debt with the bank.

Answer 10

I think part of why it is perceived is so bad is because the fluctuations in housing prices are relatively large, especially compared to the amount needed to put a down payment. This is not an uncommon scenario:

1. A family scrimps and saves for five years to get enough to make a 10% downpayment on a house.
2. The market drops 10%. Now all that savings seems like it is wiped out, and all that effort for many years was lost.

And this is not even being underwater, just being even. Imagine how much worse it feels if your dream of home ownership has turned into just a pile of debt.