What Happens When Your Mortgage Is Underwater in a Divorce

Dealing with Negative Equity During Divorce

An underwater mortgage, where you owe more on your home than it is currently worth, adds a significant layer of complexity to an already challenging divorce process. Instead of dividing an asset, you and your spouse must figure out how to handle a shared liability. While this situation is difficult, there are several strategies available to help you move forward.

Understanding Negative Equity

Negative equity occurs when the outstanding balance on your mortgage exceeds the current market value of your home. For example, if you owe $350,000 on your mortgage but your home is only worth $300,000, you are $50,000 underwater.

This situation can result from purchasing during a market peak, taking out home equity loans or lines of credit, declining property values in your area, or putting little or no money down at the time of purchase.

Options for an Underwater Home in Divorce

Option 1: Continue Making Payments and Wait

If both spouses can agree and your divorce timeline allows it, one option is to continue making mortgage payments and wait for the market to recover. One spouse typically remains in the home, and the divorce agreement specifies how the mortgage will be paid and when the home will eventually be sold. This approach requires patience and cooperation but can avoid the financial hit of selling at a loss.

Option 2: Short Sale

A short sale occurs when you sell the home for less than the mortgage balance with the lender's approval. The lender agrees to accept less than what is owed, and the remaining balance may be forgiven. Short sales can take several months to process and require lender approval, but they are often preferable to foreclosure.

Be aware that forgiven debt may be treated as taxable income. Consult with a tax advisor about whether you qualify for any exclusions under the Mortgage Forgiveness Debt Relief Act or its current extensions.

Option 3: Loan Modification

Contact your lender about modifying your loan terms. Options might include reducing the interest rate, extending the loan term, or in some cases, reducing the principal balance. A modified loan with lower payments may make it feasible for one spouse to keep the home.

Option 4: Deed in Lieu of Foreclosure

With a deed in lieu of foreclosure, you voluntarily transfer ownership of the property to the lender in exchange for being released from the mortgage obligation. This option avoids the formal foreclosure process and may be less damaging to your credit. However, not all lenders accept deeds in lieu, and there may still be tax consequences for forgiven debt.

Option 5: Strategic Default and Foreclosure

In some cases, allowing the home to go into foreclosure may be the most practical option, particularly if the negative equity is substantial and other options are not available. However, foreclosure has severe consequences for your credit score and can affect your ability to obtain future financing for seven or more years.

Dividing Negative Equity

Just as positive equity must be divided in divorce, negative equity must also be allocated between the spouses. In community property states, the debt is typically divided equally. In equitable distribution states, the court considers various factors to determine a fair allocation.

Even if one spouse is assigned responsibility for the negative equity, both spouses remain liable to the lender if both names are on the mortgage. This underscores the importance of eventually refinancing or selling the property to achieve a clean break.

Protecting Your Credit

During the divorce process, it is crucial to keep mortgage payments current. Late payments will damage both spouses' credit scores regardless of what the divorce decree says about payment responsibility. Consider setting up automatic payments and monitoring your credit reports regularly.

Moving Forward

An underwater mortgage complicates divorce, but it does not make resolution impossible. The key is to understand all available options, consider the long-term financial implications of each, and work with professionals who have experience handling these situations.

Need help with your divorce real estate situation? Our specialists offer FREE consultations.