Refinance, Stay-Put, or Sell an Underwater Home

A reader recently contacted me to get my advice on what he should do on his condominium. His mortgage is currently underwater. He wanted to know if he should try to refinance his home, stay-put with his current loan, or simply sell the home.

Situation

The reader bought a condo in 2007 for $230K with 5% down, leaving him with a loan of 218K, for 30 years @ 6.875% APR. The current balance on the loan is $200K.

After that, due to the recession, the value of the home dropped and the loan went underwater. Also, he could not refinance his home under the HARP program as his loan wasn't backed by Fannie Mae or Freedie Mac.

He did manage to save $40K through this period. This makes it possible for him to refinance now for $160K by putting $40K. But, he is thinking if it would be a wise investment because he wants to buy a single-family home in two years when his child starts school. His house is currently valued at $185K according to Zillow.

Some data points to keep in mind are that it would cost $1900 to rent a town home for himself. If he rents out his condo, he will earn about $1600-$1700 and it is not that difficult to find renters. But, the property taxes and condominium association fees will eat into the rent. Below is a breakdown of his current mortgage payment.

$1435 (mortgage) + $500 (escrow for tax) + $300 (association fees) = $2250

The reader has three possible choices:

• Sell the current home and rent a town home for a couple of years until he is ready to buy his next home.
• Refinance the current loan to a lower APR by putting $40K as a down payment.
• Stay-put and keep paying into the high interest rate loan.

Which way shall he go?

I did some quick calculations. Here is my analysis.

Option 1: Sell the home for $180K

The reader will be taking following hits if he sells the home for $180K.

$11K (@ 6% listing agent's and buyer' agent commissions)

$2K (let's assume this money goes towards repairs or buyer asks for help on closing costs)

Total of the two costs: $13K

Net proceeds from the sale of the house: $180K - $13K = $167K.

Since he owes $200K on the mortgage, he will need to send $33K from his own pocket to the bank to pay off the loan completely.

Plus, he will need to rent a town home for 2 years.

Rent: $1900

Total rent for 2 years: $45K

Total hit on the reader's pocket: $33K (loan payoff) + $45K (rent) = $78K.

The balance sheet will be $78K negative if he sells his house now.

Option 2: Refinance the loan by putting $40K as down payment

If he instead refinanced by putting $40K to bring the loan-to-value ratio of about 0.8, he will save on the rent. Plus, he will build an equity. The only downside is that $40K will be immediately needed towards the down-payment. This money could have been earning 7-8% returns if it is invested in the stock market instead.

30-year fixed loan program
Loan: $160K
Interest: 4.5%
Principal & interest: $800
Escrow: $500
Condo fees: $300
Total monthly payment: $1600
Total savings from your current loan payment: $600
Total savings over 2 years: $14K

15-year fixed loan program
Loan: $160K
Interest: 3.5%
Principal & interest: $1100
Escrow: $500
Condo fees: $300
Total monthly payment: $1900
Total savings from your current loan payment: $300
Total savings over 2 years: $7K

These savings plus the equity would be net-positive. Of course, equity will be built only if prices will appreciate further in the next 2 years. If the condo appreciates to $200K in two years, then the reader would get back roughly $27K ($40K minus agents' fees).

Option 3: Stay-put at the high interest rate mortgage

Do nothing. Continue to pay high interest rate mortgage. The only advantage is that $40K savings would be earning 7-8% returns if it is put to use in the stock markets. But, the reader is already losing 6.875% on interest charges, so the net positive is not much.
Recommendation

Do NOT sell the house. Use your $40K savings to refinance towards a low-interest mortgage. The interest rates are still low and you can lock really good rates on a 15 year term or even a 30 year term. Costco is my favorite company to shop for competitive mortgage rate at some of the lowest origination fees banks. 

Before putting $40K towards the down payment, make sure that you're saving every penny for your next down payment fund. Also, make sure you have enough emergency savings or the means to support yourself if you lose a job. In two years, evaluate your situation and decide if you want to sell the condo or rent it out.

I'm personally a big fan of 15-year loan because it builds an equity much faster in the house. If you have equity, it becomes much easier to refinance or sell the house. So, if you are able to save more such that in 2 years time, you will have enough money saved for down payment on the next house, then just go for the 15-year term. Read more here on why I like 15-year term loan.

The other thing you may want to keep in mind, in two years, you may not (do not) need to sell your house. You can simply rent it out for $1600 per month. But, for this to work in your favor, 15 year loan would be suitable because most of your rental income then would go towards the principal as opposed to interest if you had a 30 year loan.

I hope this helps you.