What does being “underwater” in your house really mean? Probably not that you're drowning.
The number of underwater homeowners – those who owe more on their mortgages than their home is now worth – has been growing sharply since 2006 as real estate prices have tumbled. By some estimates, between one in six and one in eight homeowners are in that position, most of them people who bought homes in the past few years or who put down small or no down payments.
This worries economists and policy makers, since owing more than your home is worth is the first step toward foreclosure. And it's a concern to the rest of us because foreclosures are roiling the financial markets and, closer to home, dragging down our neighborhoods. (Most people who still have equity, by contrast, would rather sell their houses at a loss than lose what's left of their investment.)
In response to concerns about rising foreclosure and delinquency rates, federal regulators are studying possible new programs aimed at needy homeowners. There are concerns that such programs could attract a flood of applications from those who don't truly need assistance or encourage lenders to push homeowners into foreclosure. At the same time, lenders such as J.P. Morgan Chase and Bank of America have committed to working on new loan terms for the most distressed homeowners.
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But experts who have studied previous sharp housing downturns in Texas, California, New York and Massachusetts say that being underwater, while unpleasant, doesn't lead huge numbers of homeowners to default on their mortgages.
Christopher Foote, Kristopher Gerardi and Paul Willen of the Boston Federal Reserve Bank studied more than 100,000 homeowners who were underwater in Massachusetts in 1991. They found that just 6.4 percent lost their homes to foreclosure over the next three years, according to a paper published in the September Journal of Urban Economics.
The vast majority of homeowners simply continued paying as usual because they focused on the affordability of their payments, not on what they owed, and they believed home values would eventually recover.
The economists found that homeowners typically lost their homes only after at least two things happened: Their home values dropped and they either couldn't afford the payments or stopped making payments after losing hope that prices would eventually recover.
Homeowners in California during the deep 1990s slump also were more likely than expected to keep paying, says Richard Green, director of the Lusk Center for Real Estate at the University of Southern California. More people turned in their keys in Ohio and Michigan during the difficult 1980s downturn because they lost faith in an economic turnaround.
Typically, homeowners fall behind after a job loss, divorce or serious illness. In the current downturn, foreclosures are higher than in previous cycles because more homeowners reached beyond their means to buy their homes and simply can't keep up the payments. As a result, the Boston economists expect that up to 8 percent of underwater Massachusetts homeowners could lose their homes between now and 2010 – a significant amount, but still not catastrophic.
So what does this all mean for you?
If you have a low-interest, fixed-rate loan, you have a valuable asset that might be hard to replace in the current market, no matter what your home's value. Keeping that mortgage current has value, even if it means cutting other household expenses.
In addition, the penalties for defaulting are great. In most cases, walking away from a mortgage can knock a top credit score down to the cellar, says Ethan Dornhelm, a senior scientist at Fair Isaac Corp., which sells credit-scoring formulas to credit bureaus.
The longer you stay in your house, the better the chances of making it through this down cycle. Though a return to peak prices may take five or 10 years, some housing markets may start to bounce back once credit becomes more available.