These so-called underwater mortgages pose a roadblock to a housing recovery, because the properties are more likely to fall into foreclosure and get dumped into an already saturated market. Home prices have fallen so much that 5,3 million U.S. households carry mortgages that are at least 20% higher than their home’s value.

Most U.S. homeowners still have equity, and nearly 24 million owner-occupied homes are mortgage free, according to the Census Bureau. But negative equity is a huge problem and risk hanging over the mortgage market. It lowers homeowners’ mobility because they can’t sell their homes, even if they want to move to get a new job.

Experts say that borrowers who owe more than 120% of their home’s value, were more likely to default. Mortgage troubles are not limited only to the unemployed. About 600,000 borrowers defaulted on mortgages last year even though they could afford to pay. Let’s take a look at one couple in Scottsdale, Arizona. They are both employed and four years ago they bought a $650,000 home in a wealthy Phoenix suburb. They believed they were getting an excellent price for the area and made a 20% down payment, using a 30 year fixed rate mortgage to pay the balance. But since than home prices on average dropped about 50% in the Phoenix area. Their home now probably is worth only $375,000 to $420,000.

Millions of families like that, who are “underwater” on their mortgages, owing more than the current value of their homes face a dilemma; keep making monthly payments or walk away and return the keys to the lender. These families are not forced out of their homes, but more often they have to dip into savings to make their mortgage payments. They lack a cushion of equity that would protect them if illness strikes or a job loss slashed their income. That makes them very vulnerable to foreclosure because they couldn’t count on selling their home for enough money to satisfy their lender. Only a huge rebound in home prices - something that appears unlikely in the near future – would give these families a shot at having equity in their houses again.

Many are asking, at what point is it worth simply throwing up your hands and preserving a remaining wealth for a future? In many cases, the first hurdle is to determine whether you live in a state that allows lender to pursue you for a deficiency judgment. A deficiency judgment means a lender can go after a borrower’s other assets if the company forecloses on the property and resells it for less than an outstanding mortgage. So if a homeowner owes the lender $400,000, and the lender forecloses and resells the property for $200,000, the lender could come after borrower’s other assets to pay up the balance of $200,000.

Many states don’t allow deficiency judgments. That allows many borrowers simply mail the keys back to the bank, of course if an owner is able to let go of the emotional attachment he has to the property. Many experts believe that a homeowner’ emotional attachment to the property fades as the home losses value. Once a house is worth less than 75% of the mortgage amount, the homeowner’s emotional attachment completely disappears. That could be a huge problem for lenders, which expect as many as 7 million additional foreclosures by the end of 2011. Lenders expect that if you haven’t lost your job or experienced some other financial hardship, you will continue to pay your mortgage, even if your home is worth half of the mortgage amount. But homeowners who choose a different path, and who think strategically about their future, may decide they are much better off handing back the keys to the lender, taking an immediate hit to their credit history and move forward with their lives.

If only a million homeowners make the decision to strategically default, it could have a huge negative impact and change the mortgage industry as we know now.

John Budz, Realty Executives, USA

Source:  Property Journal  4-5/2010