A lot of people can't escape from their homes.
Many homeowners stretched themselves to the limit to buy the most expensive properties they could afford. When home values were rising, the strategy made them look like geniuses, as they could sell at a huge profit or cash in on their equity through mortgage refinancing and home equity loans. But now, as prices have fallen dramatically in many formerly hot areas, some homeowners owe more on their mortgages than their homes are worth.
Homeowners at a loss
It's simple math. Just as cars and trucks immediately lose a big chunk of value as soon as you drive them off your dealer's lot, you aren't likely to get back what you paid for your house if you turn around and sell it shortly thereafter. With most mortgages, you don't make an appreciable dent in your principal for years. Meanwhile, many real estate agents still charge 6% of the sales proceeds as a commission. So if you bought a house for $500,000 and find yourself needing to sell it, you'll need to find a buyer willing to pay $530,000 just to break even.
The one-two punch of paying real estate commissions if they sell and having to accept prices that are lower than what they paid could leave homeowners who maxed out their mortgage debt with a big shortfall at closing. And your lender will insist that you pay up.
Sometimes you have to sell
Unfortunately, there are many situations where selling your home is the only solution. When couples divorce, it's common that neither spouse can afford to maintain the family home on a single income. People who own starter homes and choose to have children may find themselves too cramped to live comfortably. A death in the family can leave surviving family members struggling to make mortgage payments, pay taxes, and handle maintenance costs.
Changes in your job situation can also leave you with an unsolvable dilemma. On one hand, you may not be able to afford your home on a reduced income. Yet you probably won't qualify for a similar mortgage, forcing you to consider rental property as the only viable alternative.
The upside-down phenomenon mostly results from large mortgages with small or no down payments. If you made a traditional down payment of 20% on your home, you may lose most of that equity if you have to sell, but you won't have to pony up anything extra at closing. Similarly, if you decided to make a smaller down payment and instead invested your savings, you could always sell your investments to cover any shortfall. It's the people who lack both of those safety nets who face the toughest decisions.
If you're in this situation, don't panic. Contact your lender and explain the situation. It's generally in your lender's best interest to avoid foreclosure, so you may be able to negotiate new terms that you can live with.
However, don't expect to find easy answers. The best way to avoid these tough decisions is to avoid the situation in the first place. It may mean you aren't able to buy the home you want as soon as you'd like, but you'll be able to sleep better knowing that you haven't left yourself vulnerable to the whims of the housing market.
For more tips on homes, including help with mortgages, dealing with real estate agents, and negotiating the best deal, be sure to look at the Fool's Home Center. If you want more specific advice tailored to your own situation, check out the Fool's personal finance service, TMF Green Light. You'll find answers to lots of tricky financial situations. Give it a try for 30 days on us.
Fool contributor Dan Caplinger has been watching the value of his newly-bought house fall steadily on Zillow.com over the past couple of months. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy keeps you warm at night.