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Key takeaways

  • Refinancing an underwater mortgage can be difficult, but there are options available for qualified borrowers, especially those with government-backed loans.
  • To qualify for a refinance, it’s important to have a good track record of on-time mortgage payments, as well as a seasoned loan (one that's at least a year old).
  • There are potential advantages to refinancing an underwater mortgage, such as reduced interest rates and quicker loan repayment.
  • But there are also disadvantages, like closing costs and the possibility of not breaking even if you sell the home shortly after refinancing.

If you owe more on your mortgage than your home is worth, you have what’s known as an underwater or upside-down mortgage. Mortgages can become underwater when property values fall, when a homeowner takes on too much debt — or often, a combination of the two.

Being underwater is a scary state, making it challenging to sell your property and limiting other options, like using it as collateral for other loans. What if you try to refinance the mortgage for a fresh start? It won’t be easy, but you do have options. Let’s take a closer look at what underwater mortgages are, how to know if you have one and options for refinancing underwater mortgages.

$323 billion

The U.S. national aggregate value of negative equity (aka underwater mortgages) at the end of Q4 2023.

Source: CoreLogic

How to refinance an underwater mortgage

The first thing you should know: Refinancing an underwater mortgage can be tricky because you don’t have any home equity. Banks generally require borrowers to have some skin in the game — a positive ownership stake, that is — to get a home loan.

“Banks typically want to secure their interest with some amount of home equity, so it’s typically not possible to refi an underwater mortgage,” says Peter Palion, a certified financial planner in East Norwich, New York. “However, renegotiating terms on the existing loan may be an option.”

Still, refinancing could be doable. Here are the steps to take.

Step 1. Confirm your mortgage is underwater

Determining if your mortgage is underwater is simply a matter of identifying the amount you owe on your mortgage and comparing it to your property’s market value. Look at the amortization schedule you should have gotten at closing, zeroing in on how many payments (or the date) you are into the loan; the loan balance on that line indicates the amount you still owe. To determine your property’s current worth, you can ask a local broker to give you an estimated value for this preliminary purpose. At some point you will need a formal appraisal, though.

Step 2. Contact your lender

Call your lender as soon as you know your mortgage is underwater. Don’t procrastinate, even if you feel overwhelmed or uncertain. It’s best to let your lender know the situation and try to work out a reasonable plan. Ask to speak to someone who handles “problem loans.” The purpose of your call is to find out what options the lender offers, so take good notes and find out whom you need to follow up with. A paper trail could be important later on.

Step 3. Learn your options

Will anyone refinance an underwater mortgage? You may be surprised to know that some refinancing opportunities exist for qualified borrowers. While the lack of equity will limit your options, some lenders will do it for conventional loans. And even more will do it for government-backed loans.

Learn more: Compare current refinance rates

What types of underwater mortgages qualify for refinancing?

Some specialized refinance programs are designed to help homeowners in this situation, especially for those with government loans.

FHA Streamline refinance

If you already have a Federal Housing Administration (FHA) loan, an FHA Streamline refinance may make sense. “Streamline” refers to the limited documentation and underwriting done by the lender. In fact, FHA Streamline refinances don’t require a home appraisal, making it easier for homeowners to refinance underwater mortgages.

Requirements include:

  • You must have an FHA mortgage
  • The mortgage you wish to refinance must be current

USDA streamline assist refinance

The United States Department of Agriculture (USDA) offers a streamline assist refinance that may be a good option for refinancing when you’re underwater. If you’re a current USDA direct or guaranteed home loan borrower, you may qualify for a refinance loan with:

  • Low or no equity
  • No home appraisal or inspection (unless you’re a direct borrower who received a subsidy during your loan term)
  • No credit review
  • No debt-to-income ratio evaluations

Not all mortgage lenders offer USDA loans, so be prepared to shop around to find a suitable lender with the best interest rates.

Requirements include:

  • Must have a current USDA loan
  • Must be current on loan for 12 months before refinancing
  • Income must not exceed the adjusted annual income cap for your county or metropolitan statistical area

VA streamline refinance (IRRRL)

If you have a loan backed by the Department of Veterans Affairs (VA), you may qualify to get a VA streamline refinance, also known as an interest rate reduction refinance loan, or IRRRL. Like the USDA and FHA streamline loans, the VA streamline refinance is geared toward those seeking to lower their payment by getting a lower interest rate or switching from a variable-rate loan to a fixed-rate loan or both. To qualify you must:

  • Currently have a VA-backed loan
  • Be using the IRRRL option to refinance that loan
  • Currently live in or previously lived in the home on the loan

How to qualify for underwater mortgage programs

While each program has its own requirements, there are some steps you can take to help increase your chances of qualifying. Chief among them: Remain current on your mortgage payments as well as other debt payments. Most programs require that you have no late payments in the past six months and no more than one late payment in the past 12 months. A track record of making on-time mortgage payments will make your application more appealing for underwater mortgage programs.

It’s also important to ensure that your loan is seasoned before applying. Having a seasoned loan means that a specified time has passed since you took the loan out. In some cases, the seasoning requirement will be 15 months to qualify for an underwater mortgage program, while some programs may accept as little as 12 months.

Should you refinance an underwater mortgage?

Advantages of refinancing an underwater mortgage

While refinancing an underwater mortgage can be challenging, there can be some benefits to doing so. They include:

  • Quicker mortgage repayment: After refinancing, you may be able to direct the money you’re saving through reduced monthly payments toward paying down your mortgage balance faster. Your payments will be reduced either through a lower interest rate or a reduction in the principal balance on which the interest is calculated.
  • Get out from underwater: Adjusting your mortgage payments will not change the value of your home by itself, but with more affordable payments, you may be able to reduce your mortgage balance faster, so that over time that you’re no longer underwater.
  • Reduced interest rate: If you’re able to qualify for a refinance program, you may also be able to secure a better interest rate as part of the process. This will not affect your underwater status, however, unless you put the difference toward paying down the principal.

Disadvantages of refinancing an underwater mortgage

There are also cons to refinancing an underwater mortgage, which include:

  • It costs money: As with any home loan, there will probably be closing costs or other fees and expenses associated with the refinancing process.
  • You may not break even: If you leave the home shortly afterward, you lose the money spent refinancing. It’s important to consider how long you really plan to remain in a home, and to calculate the break-even point, to make the closing costs of a refi worthwhile. Your break-even point is probably around five years, but it is possible that during this period home values will rise enough to make the expense worthwhile.

Alternatives if you can’t refinance

Short sale

You can attempt to sell your home on the market and persuade the lender to accept whatever price it fetches, even if it is less than the balance you owe on the mortgage. This is called a short sale, and cannot be done without lender approval.

Short sales can take many months and require lots of paperwork. But they may be suitable if the only other option is waiting for the bank to foreclose on your home.

Deed in lieu of foreclosure

While far from ideal, some homeowners with underwater mortgages choose to forfeit the home if they can’t make payments. A deed in lieu of foreclosure is created if you decide to surrender the deed to the lender. Surrendering the property will cause less damage to your credit score than simply disappearing. It may also motivate the lender to make a deal, as they really do not want your house back.

Pay down your mortgage balance

If you’re looking to rise above water, paying down your mortgage may be the most straightforward route, assuming your budget allows. There is no point in doing this if you want to stay in the house and can make the current payments. However, it might be worth considering if you need to sell the home soon, or you want to have an easier time refinancing.

Keep in mind: Many lenders set minimum equity benchmarks for refinancing, often 20 percent. You’ll need to achieve that amount, at least, when paying down your balance.

Request a mortgage modification

One potential option for underwater mortgage relief is a loan modification. As its name suggests, this agreement modifies the terms of your home loan.

A mortgage modification agreement is not a refinance, and your lender is under no obligation to grant you new terms. However, if your lender agrees to reduce your principal balance, it may be enough to get your loan above water, or closer to being right-side up.

Just sit tight

If you want to stay in your home long term and can still afford the mortgage payments, you can choose to keep calm and carry on. Being underwater doesn’t really affect your day-to-day life. Over time, the property may regain some or all of its past value — especially if the decline in value is due to a sudden downturn in the economy or a correction of your overheated local real estate scene.

“But it could be permanent if there have been changes in your local government, property taxes, school district, nearby construction and any other factors that can impact the housing market,” says financial planner Niv Persaud, managing director of Transition Planning & Guidance in Atlanta.

Since nobody knows your neighborhood better than you (if you do your homework), you are in the best position to decide on the market’s direction and if the downturn is permanent or temporary.

Next steps for refinancing an underwater mortgage

If you’re considering refinancing an underwater mortgage, the first step is to confirm if your mortgage qualifies for any of the underwater-refi programs. Or if your conventional mortgage lender will allow it.

If you’re not currently eligible for refinancing, you may need to consider other options, including requesting a short sale or mortgage modification or continuing to pay down the balance until you’re able to rise above water.

But before you do anything drastic, analyze the reasons for your home’s drop in market value. If it’s happening to homes all around you — the result of economic or market conditions — just waiting it out might be the best plan. Don’t turn a temporary paper loss into a permanent real cash loss.

FAQ

  • An underwater mortgage, also known as negative equity, is when you owe more on your home loan (either a primary or a second mortgage) than the property is currently worth. In other words, the outstanding loan balance is greater than the home’s current market value.
  • Mortgages become underwater or upside down in two basic ways: The homeowner has too much debt secured by the property, or there’s been a decline in real estate prices that makes the home depreciate. Often, they work in tandem: The drop in the home value makes the property worth less than the debt it’s securing. Not making mortgage payments on time or in full can also lead to being underwater, as the additional interest and fees can increase the loan balance.