What exactly is an Underwater Mortgage?

Underwater mortgages are mortgage arrangements that effectively leave the owner with more debt on the property than the current market value. Generally, an underwater mortgage situation does not arise when a buyer takes out a first mortgage. The condition tends to arise when a second or third mortgage is taken out, or if factors within the area cause the property to depreciate in value unexpectedly.
One of the most common ways of getting into an underwater mortgage situation is when a property owner chooses to refinance an existing mortgage. Lenders may offer the option of borrowing on the existing equity in the property. In some instances, this can be a workable option, assuming there is a large amount of equity built up. However, if the amount of equity is relatively small, this solution can quickly lead to a level of debt on the property that exceeds the current market value. When this takes place, the property owner is essentially in an underwater mortgage situation.
Another common way that mortgages take on an underwater aspect is shifts in property values. When rezoning or other changes in the area take place, there is the possibility that the market value for the property will drop below the total of the current outstanding mortgages. This essentially creates a situation where the owner would not be able to sell the property for enough revenue to pay off all the current indebtedness.
In some instances, an underwater mortgage situation takes place because the homeowner chooses to overextend the borrowing against the property. For example, there are many lenders who will extend a third mortgage on the basis of the credit historyand job security of the applicant. However, if the owner loses his or her job and is unable to keep up the payments on all outstanding mortgages, the third mortgage effectively places the finances of the owner into an underwater situation.
A housing crunch can also create an underwater mortgage situation. When there is a demand for living space that exceeds the number of units available in the area, prices for any homes will rise significantly. The end result is that the market values temporarily rise, and mortgages are taken out to meet current prices. When the crunch is over and market values drop, owners are left owing more on their homes than the property is actually worth. At this point, the owner will find it virtually impossible to sell the property for enough to cover the cost of the mortgage, and may be more likely to default.