How long will you be underwater?
About 16 million homeowners owe more on their mortgage than their homes are worth, which means they are “underwater.” So long as that condition continues, they have no equity that can be used to help finance the purchase of another house.
On the contrary, they can’t sell the house without digging into their pockets to pay the difference between what they owe and what they can realize from the sale net of expenses.
But time heals most wounds, and negative equity is no exception. The principal component of the monthly mortgage payment reduces the loan balance by the same amount.
Refinancing into a mortgage carrying a lower interest rate reduces the interest portion of the monthly mortgage payment, thereby increasing the principal component and the rate at which the balance is paid down.
Although underwater borrowers generally can’t qualify for a refinance, those fortunate enough to have their mortgages held by Fannie Mae or Freddie Mac comprise an important exception. The government’s Home Affordable Refinance Program (HARP) permits negative equity, though borrowers must be in good standing to be eligible.
The other component of negative equity, depressed home prices, also appears to have turned the corner. Prices have begun to rise again in some areas in which the houses listed on the market have fallen short of demand from purchasers. It is plausible that within the year home prices in most areas will again be on the rise.
It is now time for underwater borrowers to start planning to get their heads above water. Calculators found online can help in that process. One type shows the borrower’s equity in the property month by month for any combination of the various factors that affect changes in equity. These include the interest rate, property appreciation rate, and extra payments.
Borrowers may want to raise their targets to cover the expenses of whatever action they plan. If the goal is to sell the house, for example, they will need positive equity of 5-7 percent to cover sales costs. This is easy to find with the calculator.
The second type of calculator is designed for underwater borrowers who want to know how much extra they have to pay each month to reach a target equity level within a specified period. For example, a borrower paying 4.5 percent wants 10 percent equity in five years and believes his house will appreciate at a rate of 1 percent a year. The calculator tells him he must pay an additional $315.50 every month for 60 months to reach his objective. If his house does not appreciate, he has to pay $418.05.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania.