Nationally, almost a quarter of all homes with mortgages are “underwater” now. I’m talking figuratively, of course, as this is California, not New Orleans. Any home which is worth less than the mortgages against it is “underwater” in financial terms. However, most of these “distressed mortgages,” as they are sometimes called, are centered in the states of California, Nevada and Florida, meaning the rate is probably higher than a quarter of all mortgaged residences in these states.

Home Sinking: Are you worried about foreclosure?

If your home is worth less than the first mortgage debt against it, and you have a substantial second mortgage, then stripping off second mortgages in Chapter 13 bankruptcy is possible. It does not give you equity in your residence right away, but may make you less underwater. This will be explored in a future blog article. This article is about how to decide whether to walk away from the home you purchased if it is underwater. This is among the toughest decisions my clients need to make, and I explore it here. How do you know whether and when to walk away?

People become very emotional about their house, often calling it their “home” interchangeably with the word “house.” This attachment is often particularized to the specifics of the building and location they currently reside in. The more the term “home” is identified with a particular piece of real estate the more the emotional identification. It often seems almost like the real estate is a family member, much like film directors will sometimes make the city they are filming in a quasi-character of the film.

Sentimentalizing the place where one lives one’s life is not a weakness. It is natural. Just as many other animals are territorial, usually for very adaptive reasons, so the “home” is a very defined human space.

I have had many homes, and I’ve sentimentalized all of them. I currently own my own home, the same one for over ten years, and except for having too much upkeep it suits me and my family quite well. I can, and do, however, have the imagination to think that other places can be my home. It is likely I will have at least one more home that is not this place.

From a financial standpoint, a house is not just a financial asset, it is a use asset as well. You need someplace to live regardless of the dollars and cents involved. In financial planning the personal residence is put on the Use Asset side of the ledger, quite apart from interests in businesses and other investments. So a personal residence has a dual quality to it. You have to look at both sides of this quality when making a dispositive decision about it. Therefore, analyzing whether to walk away from a house that is underwater has more than just dollars and cents factors to determine.

My clients and I often have very meaningful discussions in making this decision. We analyze both the use and financial factors in the particular piece of real property in question.

Among the Use Asset factors discussed are:

1.) Have you renovated the house to your particular tastes? If you have completed a remodel that feathers your nest precisely the way you like it, then it has value to you that is separate and apart from the dollar values. On the other hand, if you attempted a remodel but ran out of money and now the house is pretty much a mess, or the general contractor used up all your money without finishing, that tips the balance to the other side.
2.) Do you have school age children who need to be in a particular school that you need to reside in your current neighborhood for them to attend? If so, and a more affordable rental in your neighborhood is not available, then this can be a reason to stay put, at least until the children graduate. Alternatively, if your children are in failing schools this can be an opportunity to locate the family where schools are better.

Among the Financial Factors to discuss are:

1.) How much stress does the mortgage payment cause? I have some clients who have mortgage payments that when I learn of them I almost choke, both in absolute dollar terms, and as a percentage of their income. Traditionally, the general rule is that you want your mortgage payment to be no more than 25% of your gross income. Under the Obama administration’s mortgage-relief plan it is to be no more than 31%. I have clients who are spending over 50% of their income on the mortgage. This is not sustainable. However, if one is in sustainable ratios of income to mortgage, then staying in the home is preferred. Or if you’re income is just temporarily reduced, or you believe it will increase in the future it may be the right decision to hold onto the property.
2.) How underwater are you? Being slightly underwater is probably OK because if you were to buy another house in the future you’d have to put about 10% down. That equity you put into the new house is locked in for 8% of it because to sell a house, as a rule of thumb, it costs about 8% of the sales price. So you’d have almost no equity in that house until inflation and your debt pay down makes it sellable. So if you’re 10% underwater you can hold onto the house figuring it will keep you from having to save another down payment.
3.) What kind of mortgage do you have? There are some really toxic mortgages out there that may be affordable in today’s low interest rate environment, but when rates raise will likely make the house unaffordable. A fixed rate mortgage is much easier to predict and plan around. Many of my clients have Option ARM mortgages and have been only able to afford the first option, which is a temporarily reduced payment that causes the mortgage balance to increase each month.

Often I see consultations and clients where a role reversal has occurred. Instead of them owning the house, the house owns them. They’ve emptied out their retirement to make the payments, borrowed heavily from family and friends. When I see an obsessive relationship with an underwater and unaffordable home I usually counsel walking away, although the receptiveness to that counsel varies greatly.

However, what I advise ranges the gamut of possibilities based upon the unique circumstances of the client and the real property involved.

I have seen very few successful mortgage modifications and my colleagues and the press I have read seem to point to this as the trend. Principal reductions are very rare. More often there is an interest rate reduction and the arrearages capitalized onto the mortgage balance. That is another blog posting. However, at the end of that process, if you’re still underwater, an objective analysis as to whether it is worth it will be the same, and probably one of the most consequential financial decisions of your life.