Mighty Bargain Hunter

Debt reduction when you’re upside down

April 22nd, 2006 | by mbhunter |

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If someone takes out a new car loan with only a small down payment, it’s almost guaranteed that the person will be upside-down on their car loan. This means that the car is worth less than what’s owed on it.

Unfortunately, an increasing number of homeowners (can they even be called that?) are upside-down on their mortgages — about one in ten! For people who borrowed or refinanced last year, it’s almost three times that! This trend is largely due to the low-interest-rate-induced housing boom, and the resulting practice of lenders offering, and marginal buyers accepting, creative mortgages.

Soon this could create a negative equity epidemic, says Liz Weston of MSN Money. The triggers are rising interest rates and teaser rates on adjustable-rate and interest-only mortgages expiring. If the mortgage was interest-only, they owe exactly the same amount on the house as the day they took out the mortgage. If housing prices decline (as they have in the loftiest bubble areas) then refinancing to a fixed-rate mortgage may not be possible because the lenders will not allow the borrower to take on more debt than can be recovered from the collateral (the house) in a declining housing market.

In short, they’re stuck with two unpalatable options: higher mortgage payments (rock), or foreclosure (hard place). Certainly, some people in the bubbly real estate areas may already be facing this.

Weston does offer some advice if it looks like this might happen to you (and it’s good advice even if you have a big cushion):

• Avoid risky loans, meaning ARMs, interest-only mortgages, flexible payment mortgages, or negative amortization mortgages (ones for which you pay less than the interest owed). If you qualify for only these types of loans, you probably cannot afford the house anyway.
• Try to lock in your rate so that the payments don’t run away from you.
• Don’t borrow more! The kitchen remodel can probably wait.
• Watch the rest of your financial picture so that you can qualify for low interest rates.

She doesn’t really offer much advice for people who are already underwater. I’m not sure what I would do. What do you think of these ideas designed to avoid foreclosure under dire circumstances?  This is extreme debt reduction:

• Sell off assets to pay down the loan enough to qualify for a fixed-rate refinance. If negative equity is what prevents lenders from approving mortgages, make your equity positive if you can.
• Generate more income.  An extra $400/month take-home will cover the payment increase due to a 2% increase of the interest rate on a 30-year, $300,000 mortgage.
• Borrow from family.  Not highest on a lot of people’s lists for paying off their debts, but if the option is there, why not?  Usually the rates will be better than you can get at a bank.
• Ask your lender(s).   I don’t know how much of a hard line the holder of your mortgage will take if you ask them to let you skip a payment, but if they’re facing a loss of $50,000 or more if they have to foreclose on your home, they might take that into consideration if it will help you stay out of default.

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