Debt reduction when you’re upside-down

Debt shackles you to the people you owe. Debt reduction removes those shackles and frees up your cash flow.

What does being upside-down on a loan mean?

Being upside-down on a loan means that you owe more on your asset than it's worth. This means that even if you sell the asset that you owe against — like a car, a boat, or a house — you will still have a debt that you need to repay. This means you're paying money for the use of nothing.

If someone takes out a new car loan with only a small down payment, it's almost guaranteed that the person will be upside-down on their car loan from the beginning.

It's possible to become upside-down on loans in other ways, though. If the asset price decreases, as in a housing slump, the value might dip below what's owed on the asset. This happens more readily if the asset was secured with a low, or no, down-payment.

Upside-down mortgages hit hard

During cycles of rising home prices, money can, and has been, easier to get and at lower interest rates. The effect of this is people tend to borrow more to secure the homes. This ends up making them “house-poor” with a lot of house compared to their net worth and income.

Unfortunately, an increasing number of homeowners are upside-down on their mortgages. In the mid 2020s, a few percent are “seriously underwater” on their mortgages — about one in 42 in June of 2024. Seriously-underwater mortgages have balances that are 125% or more of the value of the house.

These homeowners are stuck in their homes unless they get out of the mortgage some other way, either through a short sale or bankruptcy. Assuming they stay in the home, the mortgage remains upside-down until the housing prices recover. This is not necessarily the worst thing if there's income and the location is good, but if either of those change, it can become restricting or financially dangerous.

What are some ways to avoid getting into an upside-down mortgage?

If you're not shouldering an underwater mortgage yet, then long-time financial columnist Liz Weston had this advice for staying out of trouble. (The 2006 article has since vanished.)

• Avoid risky loans, meaning ARMs, interest-only mortgages, flexible payment mortgages, or negative amortization mortgages (ones for which you pay less than the interest owed). If you qualify for only these types of loans, you probably cannot afford the house anyway.
• Try to lock in your rate so that the payments don't run away from you. A fixed rate on your mortgage means that your payment won't increase.
• Don't borrow more! The kitchen remodel can probably wait.
• Watch the rest of your financial picture so that you can qualify for low interest rates if the current rates you qualify for make the payments too onerous.

How about some ways to fix things if your mortgage is upside-down?

An upside-down mortgage doesn't instantly make things bad, but it does make the financial picture more precarious. The best track is to keep from making the danger worse:

• Sell off assets to pay down the loan enough to qualify for a fixed-rate refinance. If negative equity is what prevents lenders from approving mortgages, make your equity positive if you can.
• Generate more income. An extra $400/month take-home will cover the payment increase due to a 2% increase of the interest rate on a 30-year, $300,000 mortgage.
• Borrow from family. Not highest on a lot of people's lists for paying off their debts, but if the option is there, why not? Usually the rates will be better than you can get at a bank.
• Ask your lender(s). I don't know how much of a hard line the holder of your mortgage will take if you ask them to let you skip a payment, but if they're facing a loss of $50,000 or more if they have to foreclose on your home, they might take that into consideration if it will help you stay out of default.

(This article was originally published April 22, 2006, and has been updated. Header image Tim Gouw on Unsplash)