What does ‘upside down’ mean?

4/18/2006, 7:53 am

You’ve probably read the phrase ‘upside down’ in a newspaper or heard it on the news when a commentator discussed the current real estate or automobile markets.

Being ‘upside down’ means you owe more money than what you’re buying is worth. For example, if you owe $250,000 on your home and it is worth only $225,000 you’re upside down. Or if you owe $30,000 on your SUV but it’s worth $23,000, you’re upside down.

How does it happen? How is it possible to owe more to a lender than your home or auto is worth? Here are a couple of ways it can happen:

125% Mortgage Loans

I just googled ‘125% mortgage’ and found 31,000 results. A ‘125′ is a loan in which the lender gives you 125% of the value of the home you are buying. If you want to buy a $200,000 house, the lender gives you a loan for $250,000. Lenders market it as a way to ‘get the financial freedom you need’ to pay off your debts and buy a house at the same time.

You’ve seen the ads: ‘Pay off your credit cards and reduce your monthly mortgage payment!’ Unfortunately, you home becomes collateral for all the debts you pay off. And because you owe more than your home is worth, you’re upside down.

Cash Out Refi Followed by a Decline in Home Prices

Instead of the traditional approach to financial stability in which one pays off their mortgage, many are currently using a ‘Home ATM’. They are withdrawing money against the increasing value of their home.

House values have appreciated irrationally in many areas of the country. People are refinancing their mortgages and pulling cash out by borrowing against their equity.

For example, imagine a person with a home worth $250,000. Through appreciation and making monthly payments, suppose they have $50,000 in equity.

They see the ads and hear their friends talking about their new found ‘financial freedom’. They jump on the bandwagon and refinance their mortgage for the full value of their home, $250,000. Instead of $50,000 in equity, they now have $50,000 more debt which is collateralized by their home.

The $50,000 they pulled out of their ‘Home ATM’ isn’t new money. It’s not ‘financial freedom’. It’s not a bonus. It’s not the result of a good investment. It’s $50,000 of additional debt they didn’t have before they refinanced. Ouch!

Let’s continue the example. Suppose the value of real estate in their neighborhood declines by 10%. Their $250,000 is now worth $225,000. But they now owe more than $225,000 because they used their Home ATM and borrowed against their equity.

They’re upside down, owing more than their home is worth. It’s not a good thing.

Share This Post ...

Category: Financial Tips, Information | Trackback

One Comment

’tis a gift to be simple | Addison Road:

[...] made the true heroic decision for their family to live within its means. By the way, they are not upside-down, rather they are walking away with some nice equity that will ease the financial pressure they’ve [...]
5/19/2008, 6:19 pm