EP 126: Marital Home (Part 5 of 5) – How to Handle an Underwater Home

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Thank you for listening! Find a transcript of this episode below.

Now, when I originally recorded this series, I thought there were only going to be four parts to the marital home, but a fifth part came up. A very important question one of you listeners asked, and that is what do you do if your house is under water? What does that mean? Well, what happens when you have a mortgage that’s worth more than the value of your home? For example, let’s say you have a $400,000 mortgage, but the home is only worth $350,000 when you sold it, so you would lose $50,000 if you sold the house and still have that mortgage balance outstanding. Well, in that scenario, what do you do?

Well, before getting into the options, you need to have heard parts one through four, particularly part four when I discuss how you calculate the value of the home. That’s critical to understanding your options, because if you don’t know what your home is worth, you’re not going to really be able to evaluate what the best option is for you. Even if you calculate the value of the house, you need to make sure that you include important expenses from selling, because just because your house is worth $350,000 in my example, whatever the value of your house, you’re still going to have to pay broker’s fees, commissions, improvements, title IX expenses, taxes, et cetera. There are a lot of expenses involved when you sell a house, and that could equal seven or eight or 9% of the value of that house, so that $350,000 house that you’re selling, well maybe you’re going to lose a 20 or $30,000 from expenses just from selling. Maybe it’s only $320,000 house. You need to think and calculate and really understand the numbers and how bad the situation is before you can come up with a decision about what to do.

When it comes to your house, and when it comes to an underwater house in particular, there are three main options and none of them are necessarily easy. I’m going to tell you that in advance, but you’re going to have to pick the least bad option for you. Option number one is keep the house after the divorce. Number two is what’s called a short sale, and number three is foreclose on the home. Let’s go through in a little bit of detail, some of these options. The first one is keeping the house. Now, keeping the house might work for some people, but you need to understand what to expect because just because you’re keeping the house doesn’t mean that it’s going to increase in value over time. A lot of people think that just because you hold onto your house, that $350,000 house I said in the example, well, you think that it’s going to be worth $370,000 maybe in two years time and maybe $400,000 in four years if you just hold on to the house.

Well, that’s faulty logic, and you have to realize, and fortunately this has happened in recent experience, so you know it’s a possibility, but home prices do not always go up. Home prices are local, so if there’s a downturn in your local economy, particularly if it’s dependent upon something. I’m recording this from Texas, so if the oil prices, which have been low for a while, that’s hurt parts of Houston. Now, I’m not in Houston, but I know that some of the home prices have fallen in that area. Or if you’re in another part of the country and maybe there’s a lot of new homes in your neighborhood and you live in an older home, well, the value of your home might not be increasing. Then what if there’s just an overall economic downturn? That could also cause a lot of trouble. So prices are local and they don’t always go up for the house, so if you go with that logic, keeping the house for that sake is not right. It’s a dangerous expectation, and also you have to still consider all of the additional selling costs that are included in the house. Even if the house does increase some, that could be offset by a lot of selling costs that you did not anticipate before.

Now, there is an upside to selling the house. If you have that mortgage and you keep making the mortgage payment, well, normally when you make a mortgage payment, you’re paying both the principal and the interest. If you’re paying both the principal and the interest, well, the principal portion, the more of that you pay, the more equity you are building in your house because that’s the part of the loan that you’re actually paying off. That’s disappearing each month or each year, so maybe you can get to a point where you pay down the principal far enough that you start having a house with positive equity. If that’s your strategy, maybe you can consider that, but here’s the downside of course is if home prices decline for whatever reason, faster than you’re paying down the principal, well, you’re just treading water. The other thing is for a lot of people with negative equity in their home is either maybe you already have a second mortgage out on the home or a line of credit that’s, that’s pretty fully drawn. The other problem is that a lot of times their home might not be in the best state, meaning there could be a lot of issues that you have to deal with, maintenance issues or maybe some large appliances or electronics that need replacing or just some foundational issues or any number of issues with the house that you have been neglecting.

That is something that you really need to think about, and on top of all of those options as you go through the divorce process, you need to understand how much your car, your house costs to maintain every year. There’s just a lot of things to think about, because if your spousal support payments, whether or not you’re receiving them or paying them, if they impact your budget enough and you can’t keep up with a house, well, that’s a good indication that you might want to pursue one of the other options. So a lot to think about there with option number one for keeping the house. The other thing you could also possibly do, I just want to toss that out there, but I’m not getting into all the mechanics of it for now, is you could say that we’re going to keep the house after the divorce for a set period, three years or maybe five years, and after those five years we’re going to list it and sell it with the hope, of course, that you either have an increase in the prices or you paid down the principal enough on the mortgage that you can finally get rid of it. It is an option to sell it at a future date, so it’s not like you’re going to be holding onto the house for ever.

So let’s switch to option number two, which is a short sale. A short sale is another option you have, and it means selling your house and you pay down as much of the mortgage as you can and hopefully paying down the rest of the mortgage later. Now, the technicals of a short sale can vary. So using my example, you have $400,000 of mortgage outstanding, and your house when you sell it is only worth $350,000. for simplicity’s sake, you’ve got $50,000 of mortgage left. Well, under a short sale, one of two things could possibly happen. One is you keep paying down that last 50,000 over time, which is certainly an option, and then option number two is that you go to the bank and say, “Hey, we’re just going to sell the house. You all are going to take a $50,000 loss, but at least the mortgage has gone and you settle up.” Well, neither one of those options is straightforward and both have their own complications, but what you will know is that if you pursue the option where you wipe out the mortgage after selling the house, the bank will say, okay, they’ll write it off, but it will impact your credit and potentially for a long time. I actually read on one of the credit reporting agencies is that a short sale shows up on your credit report for seven years and can lower your credit score by 160 points.

It could take a long time to repair, and on top of that, a short sale, if that last $50,000 of debt is written off by the bank, it actually has a weird effect on your taxes you might not think about. I don’t remember the technical term off the top of my head, but when debt is forgiven, it’s counted as income towards you, which means that in the next year’s tax return, that $50,000 of debt is going to be treated by the government as $50,000 of additional income to you, that forgiven that. That’s going to actually increase your tax bill even though you didn’t get any money from it. Just money went away, but forgiven debt is taxed, could be taxed as income to you, so it’s complicated. Now, then of course the other option is if you keep paying down that outstanding mortgage balance, that $50,000 instead of just asking for it to be forgiven, is you’re going to still have that payment on your credit report, and you’re still going to be paying off a house that you no longer live in or own. That’s another consideration and not an ideal situation either, but of course it is an option.

Then the third option is for closure. That is what I call the give up option. It says you walk away, the bank takes the house, sells it, and that’s that. Now, while the simple concept of it is very easy in practice, it is probably one of the most complicated options, usually the worst outcome for you both financially and for your credit and for the rest of your life, and can hurt you for many, many years to come. But sometimes foreclosure is your only option, and in some cases I know that it might be the best option. But whatever the situation is, if your house is underwater, which just, as I said, just means you owe more on the house than what it’s worth. It’s not an easy situation, and you’re in a position where you are choosing the best of bad options. Ultimately, depending upon what’s going on in your divorce, you have to determine what the best, what the least bad option is for you.

So you have three main options. That is you can keep the house, you can pursue a short sale or you could foreclose on the house. I can tell you this: no option is easy. Keeping the house might be financially simplest, but it could cause a lot of pressure on you after the divorce is over, and could end up a where you’re in a position with one of the other options. You need to really understand your finances and your financial picture to make sure that you come up with the best option for you. None of these are simple and it could take five or six months just to start working through some of these options with the bank, because these are very complex processes. It’s something you just need to be aware of, and you need to be really thinking ahead and determining what’s the best option for you and when this process is over.