Terms

Underwater What it is How it Works Example

Underwater What it is How it Works Example

"Underwater" is a term for a financial contract or asset worth less than its notional value. It is commonly used to describe a house or asset with an outstanding mortgage or loan that exceeds its value.

The holder of an underwater asset possesses something without intrinsic value and actually owes more than the asset is worth.

To put it simply, being underwater means that an asset is worth less than what was paid for it. This is often the case when an asset has a loan bigger than its value.

Understanding underwater assets involves knowing that an asset is said to be underwater if the purchase price is higher than its current market value. This is particularly evident in cases involving an outstanding loan on an asset. For example, in securities trading, a trader who owns a stock on leverage may face an underwater situation if the stock holdings no longer cover the margin or loan provided by the broker. This triggering event is known as a margin call.

The concept of being underwater can also apply to non-financial assets like cars. When someone purchases a new car with a loan, they are immediately underwater because the car’s value depreciates as soon as it is driven off the lot, while the loan is paid down slowly over time. Over the years, as the loan is paid off and the car depreciates at a slower rate, the owner eventually moves back above water. For instance, in 10 years, when the loan is paid off, the car can still be sold for a few thousand dollars depending on its make and condition.

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While being underwater on a loan is not always undesirable, it is advantageous to find good deals and maintain a buffer between an asset’s value and the loan amount to avoid such situations. A margin of safety can offset potential losses.

It’s important to note that missing loan payments or violating loan terms can exacerbate the underwater situation. When borrowers encounter financial problems, seeking help from a financial planner, debt counselor, or lender can prevent the situation from worsening.

In real estate, an underwater mortgage refers to a situation where the value of a property is lower than the amount owed on the loan. This can limit the options for the homeowner, as selling or refinancing the home becomes challenging without sufficient equity. Short sales may become necessary, leading to legal disputes between the homeowner, lender, and third parties.

The issue of underwater mortgages became prominent during the 2008 financial crisis when housing prices rapidly declined.

To provide an example, consider a person who purchases a house listed at $400,000 with a $40,000 down payment (10%). They secure a loan for $360,000, which contributes to the purchase. After a few months, they discover that similar houses in the area are selling for $350,000. Despite paying down the loan to $359,000, the house is only worth $350,000, leaving the owner underwater or upside down. This situation can rectify itself if the housing market stabilizes and payments continue, eliminating the underwater status. However, being underwater for a prolonged period and by a significant amount indicates poor purchase decisions, poor timing, or unfavorable market conditions.

Several reasons can contribute to a house being underwater. Overpaying for the property or a drop in property values are common causes. Economic downturns can lead to job losses and an inability to afford homes, resulting in decreased property values. Additionally, property values can decline rapidly if a town’s primary source of employment shuts down.

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In summary, understanding underwater assets and mortgages involves recognizing when an asset’s value is less than its notional value or the outstanding loan amount. Safeguarding against being underwater requires careful consideration of the asset’s value, loan amount, and market conditions. Seeking professional advice can mitigate potential financial issues.

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