A distressing problem facing many homeowners today is the upside-down home, described as one in which the mortgage loan exceeds the property value.  Those who purchased or refinanced their residences during the years 2002 through 2006, before values began to plummet, are most likely to find themselves in this predicament, particularly in areas experiencing the greatest drop in values: California, Florida, Nevada and Arizona.

The question becomes: If you’re in this dilemma, what will you do?  The decision to stop making loan payments, so to avoid throwing good money after bad, might be tempting.  However before you simply decide to walk away, it will pay to look more carefully at three factors: cash flow, value, and adjustments you might make.

The first, and perhaps most important consideration, is whether you can afford to continue making payments.  If, in fact, the home is one you enjoy, and you’re able to handle the payments comfortably, you may be justified in doing so.  Let’s consider, for example, a home on which your monthly payments of principal, interest, taxes and insurance are $2,000—an amount you can easily cover.  If, instead, you default on your loan and, after moving out, must pay perhaps $1,700 to rent a similar house, you may be better off staying put to begin with.  It‘s true you’re throwing good money after bad, but no more so than the rent you must pay to duplicate your living conditions.  When you figure in your deduction for interest and property taxes, you’re as well off in your upside-down home.

Value, present and future, is the next consideration.  You must determine how upside down you really are.  Regardless of current market value, if your loan is no greater than reasonable replacement value, it might be advisable to stay there.  In areas which experienced horrendous collapse, the current market value of many of the properties is considerably less than the construction cost of the structure plus reasonable value of the underlying lot.  A general rule of thumb sets a 50-50 ratio of land to building.  Consider a 2,000 square foot house at $100 per square foot on a tract lot.  Its $200,000 construction cost added to $200,000 land value gives it a $400,000 reasonable replacement cost.  If its current market value is $300,000 and your mortgage loan is $350,000, it’s technically upside down by $50,000 ($350,000 – $300,000), but potentially boasts $50,000 equity ($400,000 – $350,000).  In this case, if other factors such as location or financing are right, it might be worth holding. 

There are, of course, times when property is clearly not viable.  I’ll give an actual example.  Early last year I purchased for $295,000 a 2-story, 2,800-square-foot, bank repo in the particularly hard-hit community of Canyon Lake in Riverside County.  Four year earlier a purchaser acquired it for $950,000, no cash down.  It passed to the bank by foreclosure two years later.  By my generalized rules of thumb, its reasonable replacement value is about $560,000—$280,000 for the structure and $280,000 for the land.  Encumbered with a $950,000 mortgage, the owner sensibly let it go.  Incidentally, the bank’s sale to me at $295,000 seems incomprehensible, though banks are usually incapable of handling repossessed property.

Let’s now consider the third factor: adjustments you might make.  In this environment, loans are no longer set in concrete.  If your home has negative equity or payments you cannot afford, consider changing things more in your favor.  Approach your lender to request a loan modification to terms you can live with.  Responsible lenders will prefer this to foreclosure which results in their acquiring an unwanted property.  With interest rates at historic lows, your lender might agree to a substantial reduction along with lower monthly payments.  It may even be possible to reduce the principal balance.  As for approach, contacting your lender directly is far better than hiring one of these “loan modification specialists” now crawling out from under the rocks.  In most cases these outfits merely take an up-front fee from you and do little or nothing to resolve your problems.

I’ll conclude with this final thought: History teaches that markets eventually recover.  If you like your home and can afford to carry it, consider hanging in there.