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Q: My brother-in-law has been struggling to find his ideal career in the technology field. He mentioned a great job offer he got in another city, but my sister voiced her disappointment about him likely having to turn it down. She said when they got the assessment notice for their house, they realized they’re underwater with their mortgage. I don’t really know what that means but it seems kind of crazy to turn down a job you really want. Is there some way to help them? ~Ricardo
A: Buying a house is typically the single biggest purchase most of us make in our lifetimes. We work hard to come up with the money to buy it, and then we continue working hard to pay for it. During this time, however, the value of our home may change. We hope it increases in value, but there are no guarantees. It can also decrease in value, often due to factors beyond our control. It is when it decreases in value to below what we still owe against it that we find ourselves in an underwater — or negative-equity — mortgage.
Your equity is the value of your home minus whatever you owe against it. When your home loses value or there is a market correction that decreases the value of your home, you can end up owing more than what you could sell your home for. While this isn’t a situation you want to find yourself in, there are ways to deal with it, or to avoid it entirely in the first place. Here are some things to know:
A small down payment can cause negative equity
One way negative equity happens is when you buy a home with a small down payment. If you pay less than 20 per cent down, you must also have mandatory default insurance. The cost for this insurance is a percentage based on how much of a down payment you are making. The smaller the down payment, the higher the cost for the insurance.
For example, you may buy a condo for $450,000 with a five per cent down payment ($22,500). The default insurance can then be as much as four per cent of the amount of the mortgage, i.e., $450,000 less the $22,500 down payment is $427,500, times four per cent comes to an insurance premium of $17,100. Some people pay for this insurance from their savings but most add it to their mortgage. This means that on the day you receive the keys to your new home, in addition to your down payment, closing costs, legal fees and moving expenses — none of which are part of your mortgage amount — you owe 98.8 per cent of the price you paid for the condo.
If your condo drops in value at all within the first five or so years of buying it, you will likely end up in a negative-equity position, owing more than what you could sell it for.
Can you end up underwater any other time?
Even if you have a lot of equity built up in your home, either through years of mortgage payments or buying with more than a 20 per cent down payment, a negative-equity situation could still happen. If you refinance a mortgage to borrow more money against your home, apply for a second mortgage, or take out a home equity line of credit (HELOC), you could end up owing more than what your home is worth, especially with private financing.
Canadian lenders are heavily regulated to try and prevent negative-equity situations, especially with secondary financing arrangements; however, when big mortgage debts are paired with circumstances beyond your control (e.g. municipal rezoning, market challenges, economic factors or even natural disasters), it could still happen.
How to avoid ending up underwater
When the real estate market is hot or interest rates are low, it can be tempting to buy a home, spend more on a home than you wanted to, or take advantage of additional secured credit to get a little extra cash.
Now after a period of cooling, many potential buyers are seeing a small window of opportunity to get into the real estate market. The fear of missing out is a strong motivator. However, the easiest way to avoid ending up underwater with your mortgage is to not allow yourself to get into that situation in the first place. Buy with more than a minimal down payment and/or buy and stay well below any financing amount your lender has approved you for.
How does negative equity impact other decisions?
A negative equity situation can have consequences for other decisions in your life. For instance, you may not be able to sell your home because the money you’d get from the sale wouldn’t pay off your mortgage. You’d have to come up with the difference. Not being able to sell your home might mean that you can’t move to a different city to take advantage of a job offer or to be closer to loved ones.
When your mortgage comes up for renewal, your options are also more limited if you’re already underwater. It’s harder to negotiate with your existing lender for better rates or conditions. It can also be virtually impossible to switch lenders because no lender will lend you more than the value of your home. It is always nice to have the option to switch lenders to get a great rate or mortgage with other benefits (e.g. travel points or cash back).
What can you do if you find yourself underwater?
If you find yourself in an underwater situation with your mortgage, consider your overall situation carefully. Try to determine what has caused your negative equity and if there’s anything you can do personally to turn it around.
If you are underwater because your mortgage is new or market conditions are simply what they are, do what you can to tighten up your budget a little and increase your payments even a small amount. To generate a little extra income to balance an already tight budget, maybe you could rent out a part of your home, garage or yard. There are different strategies to accelerate mortgage payments , so choose one that works for you.
If you have a large balance owing on a HELOC, second mortgage or home-equity loan , consider how best to pay those off as quickly as possible. Maybe you can sell a vacation property or spare vehicle to generate a lump-sum payment. Making extra prepayments on your first mortgage whenever possible is also a good idea. They are applied straight to your principal and affect your equity immediately.
Don’t let feeling trapped cause you to make snap decisions; base your choices on a realistic budget. Even if you can’t sell and move, could you rent out your home and live elsewhere for a lesser amount? If you can’t accelerate your mortgage payments because your budget is too tight, maybe it’s all of your other bills and debts that need taking care of first. The sooner you start looking at your options, the more you likely have available to you.
The bottom line on finding yourself in a negative-equity situation
The start of any new year generally brings with it real estate assessment notices. For the first time in several years many homeowners are becoming aware of a decrease in their home’s value and may find themselves in negative-equity circumstances. However, what the assessment notice says and what a home will actually sell for can be quite different. Your situation might not be as dire as you think, but if drowning in mortgage debt has flashed before your eyes, let that be your wake-up call to get your overall financial situation into better balance.
Scott Hannah is president of the Credit Counselling Society, a non-profit organization. For more information about managing your money or debt, contact Scott by email , check www.nomoredebts.org or call 1-888-527-8999.
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