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?

Actually in the terms of my student loans, they're specifically forgiven upon my death. I may have enough assets now to cover them if I were to liquidate them all, but technically I'm worth more dead that alive, since there's no guarantee that I won't killed by a meteor or gas explosion today. — Wayne Werner, Mar 25 '16 at 14:32
If you lose your job and have to move to get a new job, you can take your underwater car with you and still get some value out of it. A house isn't as portable. — Adrian McCarthy, Mar 25 '16 at 16:32

score 84 · Accepted Answer · answered Mar 24 '16 at 18:06

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

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?
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.
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.
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.

answered Mar 24 '16 at 18:06

farnsy

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+1 for #1. It should be noted that Federal Student Loans can be payed back on INCOME and Pay as Your Earn based repayment plans (no more than 15% and 10% of your discretionary income, respectively). There are also stipulations for public AND private borrowers to receive a student loan "forgiveness" after a certain length of time as long as the individual has been making their payments. There are two time frames for public and private, with public being a shorter time frame for forgiveness. – DukeLuke Mar 24 '16 at 18:18
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I think you should stress in point #4 that being underwater on your mortgage means loss in the even you have to sell the house, buy another one or pay out the mortgage. As long as you can keep the position, this loss is not perceived (just like a stock with a temporary plummet), but if you have to sell, you realize the loss. I think the true fear here is the monetary loss, that I believe was implied in #4. There is no "feel". the loss is real if you have to sell your position while underwater. – Mindwin Remember Monica Mar 24 '16 at 20:29
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@Mindwin True, but any loan that is under water has the property that losses are real if you sell the underlying (e.g., your car loan) and we are looking for why house loans are more frightening. If you can't reasonably move, you are basically a prisoner. If you can't reasonably sell your car...no big deal emotionally. – farnsy Mar 24 '16 at 20:38
one problem in specialist SE sites, is that the specialist (you) often leaves some assumptions under the table, and that is not clear for the layman reader (we). This can lead to confusion and misinformation by the part of the reader. I was just adding to the question by pointing what these assumptions were. that all loans have the property that losses are real if you sell the underlying. ~49% of humanity has below average intelligence. Lets cut them some slack. – Mindwin Remember Monica Mar 24 '16 at 21:06
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It might also be worth mentioning the state of the market leading up to 2008, which was full of variable-rate mortgages and predatory lending. Many people bought a house with a variable-rate mortgage (who would not be able to afford the payments after the introductory rate) because their mortgage broker assured them they could just sell at a profit if the rates went up, which doesn't work if you're underwater. – Dan Staley Mar 24 '16 at 23:40
The other difference between a car loan and a home mortgage is the timeframe - being "underwater" on a car loan isn't so scary when you know you only have to make payments for 5 years and even at the beginning of the loan, most of your payment is paying down the principal. In contrast, 30 years can literally be the rest of a person's employed life, and at the beginning of the mortgage, most of the payment is going toward interest, so it takes a long time to get above water. – Johnny Mar 25 '16 at 00:20
@farnsy: "any loan that is under water has the property that losses are real if you sell the underlying" - but for cars, the underlying value is depreciating towards zero in ~10 years anyway. If the initial depreciation is a bit faster, the subsequent depreciation will be lower. – MSalters Mar 25 '16 at 09:10
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"If the student loan situation ever comes to a head, we may have people talking about student loans in hushed tones." As someone who would own a car and be in the housing market already if not for my student loan, I can tell you that time is right now. – Zibbobz Mar 25 '16 at 13:45
@DanStaley the irony is I've known a couple of people who had variable-rate mortgages and they loved them, so apparently wherever all the rest of these people were getting VR mortgages were some seriously skeezy shops – Wayne Werner Mar 25 '16 at 14:35
Good answer for focusing on the fact that a Mortgage is secured debt. Homes will generally hold value well, but if not that leaves the borrower in a pinch. Good analogy to the car, even though I would never recommend debt on a car simply because the asset value drops like a rock. ;) – jkuz Mar 25 '16 at 15:28
Why does the term "predatory lending" sound like an oxymoron to me? If anything, it is the person who received the money that was the predator. They took more money than they are going to pay back. – Dunk Mar 29 '16 at 17:17

score 59 · Answer 2 · answered Mar 24 '16 at 18:05

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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.

answered Mar 24 '16 at 18:05

Ben Miller

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+1 for the part about being stuck in the home. I knew a few people in the last down turn who sold their place due to life changes (new job, got married, etc.) and had to bring reasonably large-sized checks to closing in order to sell their old place, then they also had to bring a large-sized check to buy their new place. Also knew some people who passed on "dream" jobs because they could not afford to sell their house and move to a new state. – Mar 24 '16 at 18:11
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Now, imagine a house mortgage with a margin call.......... shivers. – Mindwin Remember Monica Mar 24 '16 at 20:30
I know someone who went from having a fair amount of income from investment real estate to losing it all when things fell apart. She could no longer rent them for enough to pay the mortgages and with the collapse she was underwater, she couldn't sell. Now she has wrecked credit and no real estate. – Loren Pechtel Mar 25 '16 at 03:03
I partially disagree with this answer. I don't think whether or not you can afford your home is always relevant. What matters is the amount you are underwater at the time you have to move. It's possible that one reason you have to move is due to not being able to afford your home, but there are many other reasons you might have to move too, many of which have nothing to do with if you can afford your home. I just gave an answer with one example. – TTT Mar 25 '16 at 03:51
This is the specific, correct answer. It is what ultimately caused the crash in 2008 to be so bad: people losing their jobs and being unable to sell their homes for what they owe. – Joe Mar 25 '16 at 15:31
Good answer for pointing out that being upside down primarily takes away your options. When you want to sell the house is really when it is a problem. If you can wait for the value to return in the market, upside down is not necessarily a problem. Good argument to buy a house you can afford! – jkuz Mar 25 '16 at 15:32
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@Mindwin: At least in the U.S., a mortgage on a borrower's primary residence cannot be called while the borrower is current on payments and maintains ownership of the dwelling. – supercat Mar 25 '16 at 21:56
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@supercat I was talking about the call to deposit more funds (or liquidate some of the assets) when the collateral is valued way below the position. http://www.investopedia.com/terms/m/margincall.asp – Mindwin Remember Monica Mar 28 '16 at 12:57
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@Mindwin: Such calls are forbidden on mortgages issued for owner-occupied residences, at least in the U.S.; mortgage lenders are required to accept the risk that even if the value of the collateral is spiraling downward they will be unable to force liquidation. – supercat Mar 28 '16 at 15:39
Can you not sell the home, paying off most of the mortgage, and continue to make payments on the remaining principal? (just as would happen if you sold your upside-down car) Or is this not an option with mortgages? – Dan Henderson Mar 28 '16 at 19:06
@DanHenderson In general, no. The bank won't let you sell the home at a loss. – Navin Mar 29 '16 at 01:11
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@DanHenderson - a mortgage, by definition, is a loan secured on property. This is why they are (typically) cheaper than other forms of credit which are not secured, but it also means that the lender can and will prevent you selling unless you can fully clear the mortgage. – Nigel Harper Mar 29 '16 at 12:02
Ah, that makes sense. But could you not take out a separate, unsecured loan (albeit at a higher rate) for the difference, in order to be able to sell? – Dan Henderson Mar 29 '16 at 12:40
@DanHenderson maybe you could, assuming you could get enough unsecured credit, but it might be too large an amount for you to get the loan approved, and the interest rate would almost certainly be higher (and as far as I know, not tax deductible). – stannius Mar 29 '16 at 19:31

score 34 · Answer 3 · answered Mar 25 '16 at 03:38

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

You purchase a condo for $150K and live there.
5 years later you get married and your spouse wants to move in with you.
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.
You move out of the condo.
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.
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.

answered Mar 25 '16 at 03:38

TTT

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And the last option is to be forced to tell your spouse 'no' – Pimgd Mar 25 '16 at 08:37
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@Pimgd - you are braver than I. – TTT Mar 25 '16 at 13:18
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Alternatively, you could probably pay less than $50k to board your spouses dog somewhere. Sure, it's inconvenient, but it's probably the least-awful option. – Wayne Werner Mar 25 '16 at 14:36
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@WayneWerner- I don't think boarding your pet indefinitely is a sensible option as you'd never see it. You'd be better off finding a new home for it. But it's really not about the dog. There can be a myriad of reasons why one would have to move. I use the dog as an example to point out that sometimes the reason you have to move isn't something you would anticipate when purchasing a home. – TTT Mar 25 '16 at 14:47
"You purchase a condo for $150K and live there." conveniently skips stating the initial amount of the loan. Obviously this scenario implies the loan was a high percentage yet does not state why that risk was considered acceptable. The prudent thing would have been to put down a higher percentage on the initial purchase. Of course maybe then one could not have moved in the first place and then meet the future spouse and dog. The initial purchase was a highly leveraged bet. I hope the spouse aspect made it a win. – chux - Reinstate Monica Mar 25 '16 at 15:31
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@chux - it was 10% down, 5% rate. So, 135K loan and 125K owed after 5 years. But honestly you've completely missed the point. The numbers are arbitrary. – TTT Mar 25 '16 at 15:52
The numbers are not arbitrary. Had you put 40-50% down, honestly you would not be underwater. – chux - Reinstate Monica Mar 25 '16 at 15:56
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Oh my, what was I thinking? I totally should have put 50% down so that I wouldn't be underwater today! Of course, I'd also have $60K less in the bank today too... – TTT Mar 25 '16 at 16:04
How is renting defined? What if I just so happen to have friends over 24/7 when I'm not home and also they pay me? – Christopher King Mar 26 '16 at 23:17
@PyRulez - that may not be legal, but owner financing with someone who agrees (in writing) to sell the house back after 5 years might be. – NL - Apologize to Monica Mar 27 '16 at 01:15
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Keep the dog. Let the association fine you.

Rob P.

Mar 27 '16 at 01:48

@NathanL - I looked into a contract sale, and also selling a small percentage (1% ownership) to a potential renter. Courts don't fall for this and have ruled them as "sham transactions" with the sole intent of circumventing leasing restrictions: http://www.ksnlaw.com/blog/no-lease-restrictions-condominium-owners/. – TTT Mar 27 '16 at 04:11

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@RobP. - Someone tried that with a medium sized dog and ended up paying thousands in fees and court costs (either she sued or the association did when she didn't pay, I'm not sure which). She lost in court, and ended up moving and foreclosing. – TTT Mar 27 '16 at 04:13

@TTT - Owner financing is not a sham transaction, it involves regular payments to the owner, but if those payments stop, the owner retains ownership. It requires someone who is willing to jump through the hoops, which implies a longer-term lease, but it can certainly be structured in a way that you don't lose out if they decide to continue paying until you're no longer under water. The real risk is that those seeking owner financing usually have bad credit, so they may not take great care of the place. If it's someone you know well, you can reduce the risk somewhat, but not completely. – NL - Apologize to Monica Mar 28 '16 at 04:04

@NathanL - I didn't mean owner financing by itself is a sham transaction. The contract itself could remain legal, but you could still lose to the association when they sue you for violating the leasing restriction because the person living there doesn't match the legal title of the home. – TTT Mar 28 '16 at 14:22

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$50k is one expensive dog... – J... Mar 29 '16 at 14:21

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Well...on the plus side, an 11 year old dog won't be around much longer. Just don't sign any long term lease at your new place. – Dunk Mar 29 '16 at 17:25

score 18 · Answer 4 · answered Mar 25 '16 at 12:22

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.

score 6 · Answer 5 · answered Mar 25 '16 at 17:34

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.

A house not maintained most definitely does not count as "non-depreciating permanent asset". In order to retain its value, let alone appreciate in value, absent outside factors, a house must be maintained, which costs money for the owner. This can be fairly cheap and easy things like a DIY new layer of paint every 5-15 years, or large jobs like drainage or a roof replacement every several decades, but either way, it's a monetary outlay. The question then really becomes whether over time the resultant appreciation in value is greater than the cost of the maintenance. — user, Mar 27 '16 at 14:08

score 5 · Answer 6 · edited Apr 13 '17 at 12:25

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.

score 3 · Answer 7 · answered Mar 29 '16 at 14:22

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.

No rational person pays $100k for property that is only worth $50k. But that's not what happened: your friend paid $250K when the house was worth that money. What is not clear is why he ran away from it, considering that he still owes the money to the bank. — Dmitry Grigoryev, May 11 '16 at 10:06

score 3 · Answer 8 · answered Mar 29 '16 at 16:19

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....

score 2 · Answer 9 · answered Mar 25 '16 at 00:17

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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.

answered Mar 25 '16 at 00:17

cestmoi

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In all fairness, in most situations a house retains some value; house valuations don't plunge to zero with no warning. So the debt you'd have after the forced sale (whether you sell yourself, or the bank forecloses on the loan) is less than what you had before. Of course, since that debt is now unsecured, it conceivably comes with a significantly higher interest rate as well as a repayment schedule, so the financial outlay may well be greater despite the debt being less. – user Mar 27 '16 at 14:12

score 0 · Answer 10 · answered Apr 04 '16 at 19:07

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:

A family scrimps and saves for five years to get enough to make a 10% downpayment on a house.
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.

Doesn't the home ownership turn into a pile of debt the very moment you take the loan? — Dmitry Grigoryev, May 11 '16 at 10:08

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

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