Real estate investing involves several concepts that appear intimidating upon first glance. One such concept is the underwater mortgage. If you have even a casual interest in the world of finance, then you surely heard of this type of mortgage during the last housing market crisis. But what is an underwater mortgage? And how does it affect real estate investments? In this article, we will answer these questions and give you an in-depth overview of the underlying mechanisms of underwater mortgages. This will help you answer the question of whether or not to buy an underwater property for investment.
Underwater Mortgage Definition
In simple terms, an underwater mortgage is a loan that’s higher than the free-market value of the property. For example, if you owe $250,000 on your mortgage and your house depreciates down to $200,000, the mortgage is considered underwater. In this situation, the property itself can be described as an underwater property.
An underwater mortgage often occurs when there is a general economic downturn. A prime example of this is the 2008 market crash that sent property values tumbling. This situation often leaves the homeowner incapable of refinancing or selling the home.
Related: Avoiding an Underwater Mortgage: 7 Tips for Real Estate Investors
The Challenges That an Underwater Mortgage Poses for Property Owners
As we have stated above, an underwater mortgage creates several headaches for property owners. Here is a breakdown of some of these issues:
The Inability to Sell the Property
For obvious reasons, an underwater property can be extremely difficult to sell. Getting a buyer to pay anything other than market value is highly improbable. Consequently, the sale price of the home won’t be enough to cover the mortgage. Moreover, the homeowner can receive a deficiency judgment even if a sale goes through.
The Inability to Refinance the Loan
A common byproduct of an underwater mortgage is the fact that it complicates the refinancing of the loan. Underwater property owners are often incapable of getting a new loan with a lower interest rate or more lenient terms. Having said that, it’s important to note that there is an exception to this. Fannie Mae and Freddie Mac offer refinancing options in some cases.
An Increased Risk of Foreclosure
This is the most serious risk that is associated with owning an underwater property. The specter of foreclosure looms largely in this situation. The inability to refinance or sell the home can only conclude with a foreclosure. Moreover, some states have more stringent foreclosure laws than others. Homeowners should check foreclosure guidelines in their state before taking the next step.
Buying an Investment Property That Is Underwater
From a homeowner’s perspective, it would be hard to argue that there are positives to being underwater. But what about the buyer? Is there a way savvy real estate investors could leverage this situation to their benefit? Is it possible to get positive cash flow out of this investment? Let’s explore the possibilities that an underwater mortgage offers.
The First Step
Before committing to anything, the first thing that investors should do is make sure that the real estate property is truly underwater. In fact, many confuse the credit situation of the homeowner with that of the property. Just because an individual is behind on mortgage payments, that doesn’t mean the property itself is underwater. Here is what you can do to ensure that you’re buying an investment property that is indeed underwater:
- Request a Mortgage Statement From the Seller
To get a good idea of what the seller owes, you need them to provide the most recent mortgage statement. The amount of the loan that is unpaid can be found under “unpaid principal balance”.
- Determine the Market Value of the Property
The next step is assessing the current value of the property. The most reliable method of doing this is to hire a professional appraiser. Other alternative methods include asking real estate agents and checking online comps.
You can find reliable real estate comps at Mashvisor.
- Determine If the Mortgage Is Underwater or Not
Now that you have the necessary variables, simply subtract the total mortgage debt from the current market value. If the result is negative, then the mortgage is underwater.
Related: Here’s What You Need to Know About Rental Property Mortgage
The Short Sale Process
A short sale is one of the most convenient ways of acquiring underwater properties. In this case, the homeowner sells the property for an amount that is lower than what he owes on the mortgage. The sale can only go through if the lender approves the offer. Mortgage holders tend to accept these offers when they’re trying to avoid foreclosure. In fact, most of them prefer to take the small loss rather than own and manage the property themselves.
Short sale properties provide several advantages to buyers and sellers alike. For sellers, the short sale helps them avoid having a foreclosure or a bankruptcy on their credit record. For buyers, it offers them the opportunity to snatch up a high-potential property at a fire sale price.
Related: The 12 Steps of a Successful Short Sale Process
Turning an Underwater Situation Around
The key to countering an underwater situation is to turn the underwater property into an income property. One effective way to achieve this is by adding square footage to the home. Besides increasing the market value of the property, the extra square footage will help boost rental income. A thorough investment property analysis is essential if you want to ensure that you’re getting a property with some upside potential. For this purpose, you can turn to Mashvisor’s easy-to-use investment property calculator. You can learn more about this tool by clicking here.
Buying a property with an underwater mortgage can be profitable if you have the requisite experience to overturn the situation. Novice real estate investors, on the other hand, should stick to more conventional rental properties. After all, these investment properties offer a quicker return on investment without requiring the same level of risk management.