How to avoid the underwater mortgage

Q: I’ve read a lot about the possibility of first ­time home buyers ending up with an underwater mortgage? I’m not sure what this is, but it doesn’t sound good. Can you explain what an underwater mortgage is and how to avoid it? 

— Trying to be responsible, Calgary, Alta.

Answer from Robert McLister, mortgage planner with Ratespy:  No homeowner wants an underwater mortgage. It means you have negative equity—i.e., you owe your lender more than your home is worth.

If you’re making a small down payment, it’s easy to become submerged. Imagine you’re buying a $400,000 home with only 5% down, for instance (that works out to $20,000). The day you close that mortgage you’ll owe $393,680 including mandatory default insurance fees. That’s a whopping 98.4% of the purchase price.

Now imagine unemployment soars and incomes drop or people just stop buying as many houses, which sends the market into a 20% correction. Suddenly you owe about $390,000 on a property worth only $320,000. Now, my friend, you’re underwater…waaay underwater.

Negative equity causes real-life problems. For instance:

→ If you need to move (e.g., you got a job offer in another city or you split from your significant other), you’ll owe more than your home is worth and if you can’t pay it off, you’re stuck. You’d be trapped in your home with practically no way of selling it (because you can’t release the lender’s lien).

→ Lenders may be less likely to give you great rates at renewal if their internal valuation systems suggest you’re underwater.

→ You’ll have virtually no way to switch lenders at renewal if you want to get a great rate elsewhere.

How do you avoid all this? Here’s four suggestions: 

1. You rent a little longer to save up a bigger down payment
2. Buy a home as a long-term hold
3. Make extra prepayments when possible
4. Don’t overpay

Robert McLister is a mortgage planner at intelliMortgage and founder of RateSpy. 

Answer from Walter Melanson, lead analyst at PropertyGuys.com:  An underwater mortgage is when your mortgage balance is higher than the fair-market value of the home. Try to sell your home in this scenario and you’ll have to pay the extra costs out of pocket. For example, if your mortgage is $250,000, but the home is only worth $225,000 then you would need to come up with the additional $25,000 to repay the outstanding mortgage balance.

An underwater mortgage can happen for a variety of reasons, but the most common is when a buyer puts down a relatively small down payment when purchasing a home only to have the home’s value decline.  The likelihood of this happening is not great, explains PropertyGuys.com mortgage broker Sarah Albert, because Canadian lenders and consumers are very prudent. “There’s a saying in the banking industry,” says Albert, “that good loans happen in bad times and bad loans happen in good times.”

Given that Canada’s banking industry is heavily regulated and that, on the whole, our real estate values have increased, on average, by 3% annually, even buyers with a 5% down payment can avoid ending up with an underwater mortgage situation. With 5% down and even with the addition of the 3.6% default insurance premium, you’ll still have 1.4% of equity in your house.  This may not seem like much but combine that with your monthly payments and your property’s appreciation, and it’s unlikely you’ll go under. That said, there are always anomalies in the market.

The best way to avoid owing more than your home is worth is to put as much money down on your property when you first buy. You can also choose a fixed rate mortgage to keep your payments and budget stable. You could also pay for a certified appraisal prior to buying to verify that you’re not overpaying for a home. While this can cost you $1,000 or more, it could end up saving you thousands in the end.

But, in the end, the key to avoiding this situation is to do your research before buying. Know the market, understand the difference between what a home is listed for versus what it is sold for, and keep an eye on changing market conditions, such as job losses. By paying attention and getting educated, you will make better more informed decisions. 

Walter Melanson is the co-founder and lead analyst at PropertyGuys.com, Canada’s largest private sale franchise network. A background in finance, economics and technology, Walter’s true passion lies in building a more modern approach to buying and selling real estate.

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