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When Is a Home "Underwater"?

As part of the national real-estate slump, we have seen a lot of press about homes being "underwater." The other day, one of my first-time buyer clients asked me exactly what this term meant -- so let me clear up some of the confusion.

A house is "underwater" when the owner owes more on the mortgage than the house is worth. For example, if you buy a house for $400,000, taking out a $360,000 mortgage, and the market value slides to $320,000, you are "underwater" -- because you owe $360,000, and your home is worth only $320,000. Another way to say this is that you have "negative equity" of $40,000 ($360,000 - $320,000).

But mortgages aren't static. If you bought your house last month with a $360,000, 5 percent, 30-year fixed mortgage, chances are this month you owe the bank about $359,500. But if you bought your house in July 2003 with the same mortgage, you've been making payments for seven years, and you've paid off part of it, you only owe the bank $319,000 -- and you're not underwater at all.

The interest rate matters too. In the example above, if you were paying 7 percent on the 2003 mortgage, as of now you would owe the bank $330,000 -- and be underwater!

Home prices obviously matter as well. If your $400,000 home drops 20 percent in price, and then rises 20 percent, its pricing curve goes from $400,000 to $320,000 to $384,000. You're not back where you were in terms of home value, but if you took out a $360,000 mortgage you still have some equity.

The interaction of these variables causes the statistics to bounce around. For example, last fall, E. Scott Reckard of the Los Angeles Times reported that North American CoreLogic, one of the main providers of this kind of data, changed its statistical methodology to account for a couple of factors, one being the "age of mortgage" example that I presented above. As a result, the market suddenly looked markedly healthier, with the percentage of homes underwater dropping drastically, from 32.2 percent to 23 percent.

A continued recovery in home prices (depending on who you talk to, home prices either are at the beginning of a recovery - a sort of "V"-shaped curve, or started to recover in 2009 and then fell again, making the third leg of a sort of "W") would lower the numbers of underwater homeowners even further.

Does it even matter if your home is underwater? If you're employed and can make payments, probably not, because most homeowners continue to live in their homes and pay the mortgage regardless of whether their equity is negative or positive. The decision point comes when you lose your job, because suddenly it feels like there's no point sending good and scarce money after bad.

In that sense, being underwater is a risk factor for foreclosure, much as having high cholestorol is a risk factor for having a heart attack. If you own two homes and have equity in the primary but are underwater on a somewhat-recently-purchased vacation home -- a situation that a few people I know are in -- it may be time for a fiscal overhaul that doesn't necessarily include foreclosure. I'll come back to this topic in the next couple of weeks, and we'll look a little more at what's behind the numbers.

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