What if You're Upside Down on Your Mortgage and Need to Move?

In my previous post about being upside down on a mortgage, I said that you're probably not going to be able to move anytime soon. Well, what happens if you're upside down and need to move? You have options, but none of them are magical or ideal. This post will describe a few of them: borrowing money to make up the difference, negotiating a short sale, and foreclosing.

Two big variables that will greatly affect your situation are 1) the amount you are upside-down and 2) the degree to which you can afford to keep paying your mortgage. If you are upside down $50,000 versus $5,000, you're in a much more difficult situation. Likewise, if you're able to keep making your mortgage payments until you figure out a long-term solution, you're in a much better position than someone who is unable to make his or her payments. If you can't make your payments now, consider renting out the home after you move or drastically changing your current budget to make ends meet. When you move, rent a small inexpensive place. If your kids are in college, consider asking them to take time off or to absorb some of the costs themselves. Major lifestyle changes are difficult, but the effects of a foreclosure or a short sale can be detrimental; all efforts should be exhausted to ensure that neither of those two occur.

If you are upside down on your mortgage and are put in a position where you need to move -- whether it's because of a job transfer or an unexpected layoff -- the most ideal option is to keep your home until you are no longer upside down. This can be achieved by saving money to match your negative equity or waiting for the market to pick up. Three alternatives are described below in order from best to worst as they relate to your overall financial (and emotional) wellbeing.

Option 1: Borrowing the money
This is an option as long as you're slightly upside down and not really upside down. If your negative equity is no more than $10,000, you're not in such a tough place. By borrowing money to get out of the pinch, you're protecting your credit score from getting hit by a train and ensuring that you'll be able to get another loan sometime in your lifetime.

The best place to get a loan for $10,000 or less would be from a friend or family member. But if you borrow money from someone, they'll need to charge you interest (at least 4.52%) in order for the IRS not to consider it a gift. A person is allowed give gifts to another up to $12,000 per year.

If you're fresh out of rich relatives, there are other places to look. If you, your child, or your spouse is enrolled in college, you may be eligible to take out an additional student loan. The federal government will allow students and parents to borrow money in excess of actual tuition and fees to cover living expenses. It would not be uncommon for students and parents to be able to borrow an extra $7,000 or $8,000 per semester which is available in cash. These loans have a relatively low interest rate (between 6% and 8%), are repayable over a long period of time, and their interest is generally tax deductible.

I hate to say it, but if you're unable to get a favorable loan from a family member or the government, you may have to resort to using a credit card convenience check or obtaining a high-interest personal loan. I'm not usually a proponent of putting things on your credit card that you can't pay off immediately. But in this case, when a foreclosure or a short sale are your only other options, the convenience check is the lesser of two evils. I'd rather see you incur five or ten thousand dollars of credit card debt if it means you'll avoid a foreclosure or a short sale.

Option 2: Negotiating a short sale
Short selling is when you negotiate with the mortgage lender to accept a fair market price for the home instead of the amount that you actually owe. This is more likely to be accepted when home values in a certain area have dropped significantly. Though mortgage lenders are not required to modify your agreement and accept less than you owe, they may be willing to because it may prevent a foreclosure, which is very expensive for a bank. Basically, they would rather forgive $10,000 on your loan than incur $70,000 in costs associated with a foreclosure.

Short selling is similar to foreclosing, but it will ultimately cost the bank less money and permit you to buy another home a bit sooner. It is preferable to a foreclosure, but is only offered by some lenders to some borrowers, depending on the circumstances. I had to do a bit of research to confirm this, but short-selling on your home will cause as much immediate detriment to your credit score as a foreclosure.

Expect your FICO score to drop 200 or 300 points. Your new score will most likely preclude you from qualifying for a rental lease without a cosigner. However, with two years of good credit history following a short sale, you will probably be able to obtain a mortgage through special government-sponsored programs. If you had foreclosed, you most likely would be unable to qualify for another mortgage for at least four years.

If you want to short sell your home, two things need to happen. 1) The mortgage lender has to be willing (it helps to have a lawyer assist with the negotiations) and 2) you need to prove your insolvency. Basically, you need to show that you have no money that can be freed up to pay for the difference between what you owe and what the house is worth. If you have equity in another property, a car that is paid off, or a student enrolled in college, the bank will see these things and ask why you're not dipping into your other equity, selling the car, or taking your kid out of college to pay what you has originally agreed. Essentially, before the bank concedes a short sale, they will need to be assured that foreclosure is the only other option because you have no other means to repay the loan.

Option 3: Foreclosure
This is clearly the worst thing for everyone. Your credit score will be destroyed and its affects will be long lasting. You will be unlikely to receive any other type of loan for a few years. The only good news is that no negative item - including a foreclosure - can stay on your credit report for more than seven years.

Being upside down on a house is a tricky situation -- especially for those that need to move. If you're upside on the mortgage for your current residence, save as much as you can so you can eventually bring get rid of the negative equity. If you need to move, do whatever you can to keep the home until house values go back up. If you cannot keep the home, try to borrow money from a friend or from the Department of Education. Remember that it's better to put an extra five or ten thousand dollars on a credit card than go through a short sale or foreclosure. If you're unable to obtain the cash to get out of the red, try to negotiate a short sale. It's effects on your credit are detrimental, but not as long-lasting as a foreclosure. If your lender is unwilling to engage in a short sale, then foreclosure may be your only option.

Guidelines for accelerated loan payoffs

If you've been frustrated with the faltering markets lately, as have most Americans, you've probably been discouraged from investing your disposable income into the stock market. That could very well be the correct choice for you and your family, depending on your financial plans and tolerance for risk. But if you're not investing in the stock market, what are you doing with all that money? Are you putting it in a savings account? Or a CD? Or are you paying down debt?

My personal financial plan calls on paying down my debt during the economic downturn. The markets have been unpredictable (and by unpredictable, I mean they're going straight down) and the amount of debt that my wife and I have will take a relatively short amount of time to pay off. We're hoping that when we're out of debt in a couple of years (excepting our mortgage), the market will be trending upward and we'll have a larger portion of our income to regularly invest, given the fact that we'll have no regular payments for our auto or student loans.

If you're going to start paying down debt in lieu of investing, consider the following three guidelines to help you prioritize where your money is being sent:

1. Pay off the loans with the highest interest rate first (as long as they're not tax advantaged)
Dave Ramsey will tell you to pay off your loan with the smallest amount first instead of the one with the highest interest rate. This adds a layer of subjectivity to your personal finance that, while making you "feel good" about paying down your debt, will cost you money. In a recent post, I discuss the financial disadvantages his plan.

Non-tax-advantaged loans that fall into this category include credit card debt, personal loans, and auto loans. Look for your highest interest rate, and start sending whatever extra money that you can to pay it off.

2. Pay off loans incrementally -- don't save your money and pay it off in one fell swoop
I'll give a personal example here. Though I still have a couple of years' worth of payments remaining on my auto loan, I'm hoping to have it paid off by January. While maintaining my "emergency fund" in my checking account, and have been placing my monthly disposable income into an "auto loan payoff fund" that lives in a savings account. Last I checked, I had a few thousand dollars in there.

I had originally planned to keep making my regular monthly payments and continue saving money in the payoff account until I had enough money to pay off the car. But then I crunched a few numbers and found the flaw in my plan. Here's how it goes:

Whenever you make a regular monthly payment on a loan, a portion of that payment goes toward the principal balance and another portion goes toward interest. Those percentages are determined by a couple of different factors:
1) the time left on the loan (the less time left, the higher the percent that goes toward principal) and
2) the amount of remaining principal balance (the lower the balance, the higher the percent that goes toward principal).

So if my monthly payment is $500, maybe $400 of that goes toward principal and the other $100 goes toward interest. Next month, after the principal balance has been slightly reduced, the payment distribution may be $405/95, and so on. But if I have a few thousand dollars in a savings account that's just waiting to be used to pay off the loan, I am better off sending that money as a principal-only payment immediately. If I reduce my principal by, let's say, $5,000, a much higher percentage of my regular monthly payment will go toward principal. If you're paying off a loan on an accelerated schedule, sending the extra money as soon as you have it instead of saving it and sending one big fat check at the end may save you several hundred dollars over the life of the loan.

3) After non-tax-advantaged loans are repaid, evaluate the tax benefits of other loans before repaying them.
Once your credit cards, personal loans, and auto loans are paid off, hopefully all you'll have left is a mortgage and maybe a student loan. At this time, before deciding to accelerate the payoff on these loans, you should reevaluate the stock market. Has it picked up yet? If you're still not feeling warm and fuzzy, do some math and figure out how much your tax-advantaged debt is really costing you.

If your mortgage has a 5% interest rate, remember that depending on your tax bracket, you'll get maybe 25 or 28 percent of that interest back in your tax refund. So think of the effective cost of the debt to be 3.75% (5%, minus 25% of the 5). Your mortgage is a very long-term loan, and you won't see the benefits of paying it down early for a very long time. Paying it off early won't reduce your monthly payments. Sure, it will be paid off sooner, but even if you double your monthly mortgage payment every month until it is paid off, it will take almost 10 years to pay off a 30-year mortgage. If the effective interest rate on your mortgage (the interest rate less the tax benefit) is only slightly higher than the amount you could earn in a CD or a savings account, I would rather see you hold onto that money just in case you need it.

With all loans, especially those that are tax-advantaged, the lower the interest rate, the less sense it makes to accelerate your payoff. My friend Quang's student loan has a 3% interest rate. I wouldn't pay that off early for the world. But the rate on one of my wife's student loans is 7.9%. I can promise you that as soon as my car is paid off, the next thing to go will be that sucker.

Non-tax advantaged debt is nobody's friend. If you're not satisfied with the performance of your investment portfolio, it could be a wise decision to pay it off early in lieu of investing. But if your only debts are mortgages or student loans, think twice before you start sending extra cash toward the principal. True, you're saving yourself money in the long run, but remember that you're also reducing your tax writeoff and parting with that money for a long, long time. And keep in mind: even if you're using the standard deduction (not itemizing), your student loan interest is still tax deductible!

Paying down that mound of student loans

A reader of my site sent me a private message describing an intimidating financial situation that she found herself in. After attending an expensive out-of-state college and starting grad school, she has found herself with $140,000 in student loans. Let me just say this: if your parents paid for your education, call them today and thank them.

I called her while driving back home from a business trip to talk it over. In this post I'll describe to you some of the specifics of her situation, some options that she was considering, the advice that I gave her, and the numbers that I crunched when I got back home, and my final conclusion.

Specifics:
Current sum of balances: $140,000
Current interest rate: varies; different loans have different rates ranging from 4.5% to 7.5%
Current salary: $60,000
Current credit: So-so, but her father has good credit and is willing to co-sign
Current living expenses: limited, as she is living with her grandmother

Options she was considering:
#1 - Buying a house and consolidating the student loan debt into the mortgage:
Her father suggested doing this, but she wasn't sure about her options. I can't say that this is not necessarily bad advice, but it really isn't an option. Here's why:

Depending on your situation, down payment, and credit score, mortgage lenders may be willing to give you some extra cash to help with certain expenses, like necessary repairs or closing costs. However, they're very careful about not giving you too much money, as they don't want the balance of the mortgage to exceed the value of the home because the home is used as collateral.

Mortgages tend to have lower interest rates than personal loans, credit cards, and student loan consolidations. That's because they present less risk to the lender because the loan is secured with an actual house. If you don't pay your loan back, the bank can seize and sell your home. The same goes for car loans. On the other hand, if you fail to repay your student loan or a personal loan, sure, the bank can destroy your credit, but they're S-O-L when it comes to getting their money back.

If my reader were to roll her student loans in with her mortgage, the balance on the mortgage would be $140,000 more than the cost of the home, less the down payment. So unless she was putting at least $140,000 down on the house, the bank would be "upside down" on her loan -- meaning they were owed a lot more than the collateral was worth. Banks don't like to be upside down, so her request would likely be denied.

On a side note, this type of lending and borrowing was a root cause of the recent economic downturn. People bought homes and assumed that, because of the housing bubble, the value of their homes would skyrocket and they would have incredible amounts of equity. Let's say I bought a house for $200,000 with no down payment. At first glance, I would have zero equity. But if after a couple of months the house was assessed at $300,000, my equity would be $100,000 and my bank would potentially loan me up to that amount in a home equity loan. This happened often and sounded great to everybody. But as home values eventually declined, all of that false equity diminished. All of the sudden, people that exercised these types of loans owed $300,000 on a home that was now only worth $175,000...but I digress.

#2 - Consolidating her private loans
My friend has a combination of federal and private student loans. Her federal loans are already consolidated at 4.5% -- a rate I wouldn't part with for the world. Her private loans (which I assume are the majority, given the high sum of her balances) have interest rates which vary from 6.5 to 7.5 percent.

This morning I looked into the cost of consolidating private loans. Turns out, it's more expensive than I had imagined. According to studentloanconsolidator.com, consolidating your private student loans will give you a variable interest rate from 7.9 to 11.93 percent and smack you with a one-time consolidation fee of 1-5%. I've got to say, that's pretty expensive! Of course, there are other options out there, but the consolidation of private student loans are very very expensive, especially considering my reader's current 6.5 to 7.5 percent interest rate.

The advice that I gave her on the phone:
When we spoke, I was in the car and didn't have time to research the total cost of paying back her loans or her consolidation options. I told her that consolidating her loans with a mortgage were simply not an option because she wouldn't have enough equity in the home. I told her to continue living with her grandmother as long as she could stand it and keep sending extra money to her lenders. I told her to start keeping track of her money -- how much she has, where it goes, etc, by using my favorite site on earth, mint.com. Finally, I told her to save a couple of months' pay in an emergency fund.

The numbers I crunched this morning:
Assuming a $140,000 principal balance, a 20-year payback period (common when it comes to loans), and an average rate of 7%, her regular monthly payments are probably somewhere around $1,085 per month. If I knew what her actual monthly payments were, I could be more certain about her average interest rate.

By paying that minimum payment each month, her student loans will be paid off in 20 years. However, if she sends and extra $500 per month toward the principal, her loans will be paid off in just over 10 years. If she can scrape together an extra $700 per month, the loan will be paid off in less than 9 years.

If some of her loans carried a higher interest rate, she could consider asking her father to take out a home equity loan for her. Because he's willing to co-sign on a loan, he's already shown that he's willing to put his credit and cash on the line to help out his daughter. Assuming that he owns his home and has considerable home equity, he could take out a home equity loan with a potentially low interest rate and pay off her student loans. The thing to consider is that home equity loans typically last for 30 years, so this would only be a valuable option for her if she were to 1) pay off the loan early and 2) obtain a lower interest rate than the highest of her student loan rates.

Final conclusion:
My friend is really in no position to purchase a home at this point. Her current student loans really resemble a mortgage. At her current income level, I would expect that she could afford a home worth approximately $140,000 to $180,000 dollars. But because her $140,000 in debt doesn't come with a house, she doesn't have the option to "live in her investment" or rent out a room. I would recommend that she refrain from buying a home until the balances on her student loans are cut down to at least $50,000.

If her student loans each carry different interest rates, she should start by paying down the one with the highest interest rate. Once that's paid off, she should start paying off the next one and the next one and so on. I recommend that she do this methodically and automatically by setting up regular payments with her bank. But she should make sure that the extra payments are going toward principal and not toward next month's payment.

An education is a valuable thing -- and an expensive one, too. Student loans are a part of life for many people, including myself, my wife, and many of our friends. By being smart about paying them down and using all of the resources available to you, you can bring your balance to a big fat zero in no time. Then, you'll be able to start saving that money for your own child's education!

To my reader that called asking for help: feel free to send me an email with the specifics of your loans. I've built some calculators that will help optimize their payoff, ensuring that in the end you're paying as little as possible.