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What Is An Upside-Down Mortgage?

What Is an Upside-Down Mortgage?

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When you buy a home, you hope the value will appreciate over time so you’ll be able to build equity. Of course, it doesn’t always work out that way.

Home values in neighborhoods can rise sharply for relatively simple reasons such as a major improvement in public transportation. Home values can also plummet.

These fluctuations can have serious financial repercussions—if you purchase before a drop, you could find yourself upside down on your mortgage.

Definition

An upside-down mortgage is simply a mortgage in which the owner owes more than the house is worth. If you can afford the monthly mortgage payments and don’t want to move, being upside down may not have an immediate effect. However, it will take longer to build equity in your home, which will affect your ability to refinance or sell your home and make a profit.

Fluctuation in home values

Volatility in neighborhood home values is the biggest cause of upside-down mortgage situations. Sometimes this instability benefits home buyers. When the housing market is strong, buyers can get a home at a relatively low price and sell it a few years later and make thousands of dollars in profit. The opposite is also true. A buyer who purchases a house at peak value stands to lose money when its value falls.

Nontraditional mortgages

Nontraditional mortgages—also called exotic or high-risk mortgages—can lead a homeowner into an upside-down mortgage situation or make it worse. Some mortgages allow interest-only payments for the first few years, which keeps payments low but doesn’t make a dent in the principal or build equity. Monthly payments on negative amortization mortgages don’t even cover the full interest costs. Instead, the interest payment is deferred and added to the principal. On these mortgages, a home buyer ends up owing more than the original loan. Homeowners in the first few years of these mortgages have little equity in their home.

Selling your home

Selling when you have an upside-down mortgage can be tricky. Buying or selling a home involves additional expenses such as closing costs, lawyer fees, and real estate agent fees. Some mortgages have prepayment penalties that actually charge the mortgage holder for paying off the mortgage before it comes to term. These fees and penalties add to the cost of selling a house, and increase the amount of money that you’ll owe when leaving your home.

If selling on your own isn’t an option and you’re falling behind on payments, some lenders will accept a short sale and forgive the difference between the amount of the sale and the total mortgage loan. However, this will damage your credit and may hurt your chances of qualifying for another home in the future.

The simplest solution for homeowners with upside-down mortgages is to continue making mortgage payments, if possible, and wait for home prices to rise again before selling their homes.

Updated from an earlier version by Dini Harris