When you owe more than your home is worth, you may be dealing with an underwater mortgage. Having an underwater mortgage is not an ideal scenario and can result in excess risk to your finances. It can affect your ability to refinance your mortgage or sell your home – in short, it’s something you want to avoid.
But how do you know if you have an underwater mortgage, and how can you take steps to manage one, if you’ve found yourself in that position? Here’s what you need to know about underwater mortgages.
What is an Underwater Mortgage?
An underwater mortgage happens when you owe more to your lender than your home is worth. For example, if your mortgage balance is $500,000, but your home is worth $450,000. You are “underwater” on your mortgage because you would still owe your lender money even if you sold your home, and you would need to pay the lender the remaining difference.
An underwater mortgage can happen for several reasons, both within your control, like missing mortgage payments, and due to factors you can’t control, like your local real estate market.
What Causes an Underwater Mortgage?
An underwater mortgage can happen for many reasons, all of them either falling into the category of not paying down your loan principal, or the value of your home depreciating. Here are some common reasons for an underwater mortgage.
Decreased Home Value
Home prices aren’t set in stone and go up and down depending on local market conditions. While homes in Canada have traditionally risen in value over time, there are several periods in history when home prices have dropped, one as recently as 2022.
Home values dropping even a few percentage points can leave you with an underwater mortgage. For example, if you purchase a home for $500,000 with 5% down, you’re mortgage will be $494,000 after adding $19,000 in CMHC mortgage default insurance premiums. That means if your home’s value drops just $6,000 ($500,000 – $494,000), your mortgage will be larger than the home’s value, leading to an underwater mortgage.
Rising Interest Rates
Interest rates have risen precipitously over the past few years, which increases the cost of servicing your mortgage. In some cases, variable rate mortgage holders have even hit their trigger rate, which is the interest rate at which you are no longer paying down the interest on your mortgage. If that happens, you aren’t increasing your equity in your home, and you become vulnerable to decreasing home prices.
Missing Mortgage Payments
You can also send your mortgage underwater if you miss your mortgage payments. Many lenders offer a “skip a payment” option with their mortgages, which lets homeowners skip payments once annually. While this option can be helpful if you experience job loss or another unexpected life event, the has some downsides and can land you in an underwater mortgage.
When you take out a new mortgage, most of your monthly payments will go toward the interest portion of your loan. As you make your mortgage payments, more and more of your costs go toward reducing the overall balance. When you skip a payment, the interest portion of your payment isn’t paid off and will accumulate. This means you won’t make as much progress on paying down your mortgage as you would if you never missed a payment. Combine that lack of progress with dipping home prices, and you may find yourself with an underwater mortgage.
Your Mortgage is Underwater – What Now?
If you suspect your mortgage is underwater, the first step you’ll need to take is to confirm your suspicions. You can do that by taking three steps:
- Verify your current loan balance: Find out how much is owed on your mortgage, either through your lender’s online banking portal or by calling them directly.
- Estimate your home’s worth: Determine how much your home is worth by using a home valuation estimator from a real estate website or by hiring an appraiser to evaluate your home.
- Subtract your loan balance from your home’s value: If your mortgage is a larger number than the value of your home, your mortgage is underwater. For example, if your home is valued at $500,000, but you owe $550,000 remaining on your mortgage, you are underwater by $50,000.
If you’ve found that your home is underwater, don’t panic. If you can keep up with your mortgage payments, you may be able to wait until home prices rebound and your home’s value rises enough that you are no longer underwater. You generally won’t encounter problems with an underwater mortgage if you don’t attempt to sell your home or refinance your mortgage.
Risks of an Underwater Mortgage
While having an underwater mortgage isn’t a reason to panic or take action immediately, it does carry some risks.
Defaulting on Your Mortgage
If you are having problems keeping up with your mortgage payments, you risk putting your mortgage into default. If that happens, your lender could force the sale of your home, and you’ll still owe your lender the difference between the sale price and the remaining loan balance.
Harming Your Credit Score
If you’re underwater on your mortgage because you’ve been missing payments, your credit score may be affected. If your mortgage goes into default, your credit score will be severely impacted.
Not Able to Refinance
If you need to change the terms of your mortgage, for example, accessing more equity or lengthening or shortening the length of your loan, you may not be able to if you owe more on the home than it is worth. New lenders may turn down your application, and your existing lender may even require a lump sum payment to bring your mortgage back into good standing before they refinance your home.
How to Get Out of an Underwater Mortgage
Being underwater on your mortgage isn’t a reason to panic, but you should take prompt action to bring your mortgage back into good standing. Here are some ways to get your underwater mortgage above water.
Rent the Home Out
If you can’t sell your home due to an underwater mortgage, consider renting it out until the market improves or you pay down enough of the loan that you’re no longer underwater. If you want to stay in the home, you could consider renting out a room in the home, and using the extra income to pay down the mortgage quicker.
Wait It Out
If your mortgage is underwater because home prices in your area have dropped, waiting for them to rebound could solve your problem. Home prices have a long history of growth, but it may take some time for prices to fully recover.
Raise the Value of Your Home
Another way to get out of negative equity is to raise the value of your home. The more your home is worth—even in a real estate market decline—the smaller the chance of an underwater mortgage.
A few ways to increase the value of your home are to:
- Adding a patio, deck or outdoor living space
- Improving the curb appeal
- Adding more living space (such as finishing the basement or converting the attic)
- Upgrading your kitchen or bathroom
Keep in mind that whatever you do to raise the value of your home, be sure that you can afford to take on this cost and that the upgrade plan doesn’t push you into more debt.
Make Extra Payments
If you can, make extra payments to your mortgage lender. Most lenders allow you to make an extra payment, double-up payments, or make a lump-sum payment towards the principal loan balance. These extra payments will reduce your loan balance and could get you out of underwater territory.
If making an extra payment is too much of a stretch, consider changing your payment frequency. Switching from monthly to biweekly mortgage payments means making an extra mortgage payment each year—so 13 months of payments, rather than 12 months.
Final Thoughts
In a real estate market where home prices are declining—or there is a potential for price drops—homeowners need to pay attention to their own balance sheet and learn when and if a negative equity situation could happen.
Remember, while a home is an asset – it isn’t an investment. You don’t have to earn or make money on your home year after year. That said, negative equity can make it challenging to sell your home, so you’ll want to pay attention to the factors that are beyond your control, such as falling home values, or rising mortgage rates. That said, there are some factors you can control, such as avoiding high-interest loans, cutting spending, increasing your down payment and tackling mortgage debt, early. Do this, and you’ll weather any market storm the real estate cycles throw at you.
