Handling Negative Home Equity During a Divorce

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This article was republished by Investopedia here.

Your marital home is one of the largest assets that will need to be considered during a divorce. However, what do you do if your current mortgage is underwater? When you and your spouse owe more than the house is worth, it can alter the options available to you. For your settlement negotiations, you must make sure you understand the implications of owing more than your house is worth.

How Negative Is Your Home Equity?

The first thing you need to assess is just how far underwater your current mortgage is. One of the best ways to determine the current value of the home is to hire an appraiser. In order to give you a realistic picture of the market value of your home, a good appraiser should be familiar with the area where your home is located. This appraisal will give you a quick idea of the overall deficit on your mortgage.

However, you still need to factor in other costs that could enlarge your deficit even further. If you decide to sell your underwater home, you may still need to factor in realtors’ fees and closing costs. Search through records to determine if there are any liens placed against your property, which will also need to be addressed prior to selling the home. To determine the overall deficit on your current mortgage, all of these additional costs must be factored in.

Once you understand just how far underwater your mortgage is, you stand a much better chance of selecting the correct options moving forward (for you and your spouse). As such, these three options should be on the table when your current mortgage has a large deficit:

Option 1: Keep the House

This option is highly dependent on whether or not you can afford to keep the house as a single person. With the loss of one income, many people find that it is financially unrealistic to remain in the marital home. The mortgage payments should not leave you financially strapped on a monthly basis. If they do, then you will need to consider another option. 

Regarding keeping the house, several factors may play into your divorce settlement. Some couples choose to remain in the marital home until a set date, such as when their children graduate from high school. In situations like these, you can opt to set the property division for a specified date in the future. In the meantime, you can work towards paying down the mortgage. 

Alternatively, negative equity may factor into your divorce settlement. In other words, a spouse who opts to keep the marital home may be granted a bigger portion of a different asset to make up for the deficit. Factoring negative equity into the settlement is a way to maintain the marital home for yourself and your children while still securing a stable financial future for yourself.

Option 2: Opt for a Short Sale

If you know that you can no longer afford the home with just a single source of income, it may be time to consider a short sale as an alternative to foreclosure. This option allows you to pay off some of your current mortgage and potentially repay the remainder of the debt later.

In order to consider short-selling your house, you must first receive approval from your lender. Since a divorce would mean the loss of one income toward your mortgage payment, you may qualify for approval. 

Depending on your state laws, a short sale may mean that many of your debts will be canceled. Other states allow for recourse loans, which enable lenders to take homeowners with short sales to court; therefore, they can make payment arrangements for the remaining debt. Solutions for the latter could end in situations such as wage garnishment. If you happen to have a recourse loan, the remaining debt could be divided between spouses during mediation or litigation. 

Bear in mind that a short sale can significantly damage to your credit score. Slightly greater than a foreclosure, a short sale that puts large dents in your credit score will make it more difficult for you to secure funding in the future. Receiving approval for an auto loan or new mortgage may be a challenge. As a result of your lowered credit score, you may even face higher rates or less favorable terms.

Many homeowners are unaware that there could also be serious tax implications associated with a short sale. If you live in a state where your debt is canceled as the result of a completed short sale, the IRS could be more likely to consider that debt cancelation as a form of income for the year. This additional income often translates into thousands of dollars, so it may result in exorbitant, unexpected tax bills at the end of the year.

Option 3: Face Foreclosure

Perhaps the bank will not allow a short sale, and you can no longer afford the home. If so, you may be forced into foreclosure. This situation can severely impact your credit for the next seven years (or longer, depending on how long it takes to resolve the foreclosure). Therefore, when it comes to resolving the issue of an underwater mortgage on your marital home, this option is the last resort. 

Understand the Deficit Before You Decide

Before you can make any educated decisions regarding the status of your marital home, you need to consider the overall deficit you face on your current mortgage. If you know where you stand regarding your finances, you can weigh all of the options in the wisest manner possible.

Divorce is an emotional process, and discussing the loss of your marital home can significantly contribute to that feeling. If you separate your emotions from the situation at hand, you and your spouse can focus on what is best for both of your financial futures.

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Shawn Leamon, MBA, CDFA is author of Divorce and Your Money: The No-Nonsense Guide and host of the Divorce and Your Money Show on iTunes. Learn more at  www.divorceandyourmoney.com.

Shawn Leamon, MBA, CDFA

Dallas, Texas

Shawn C. H. Leamon is Managing Partner of LaGrande Global, a firm that helps successful families manage large financial transitions like divorce, inheritance and selling a business.

He earned his Bachelor of Arts from Dartmouth College, double majoring in Economics and Philosophy, and his Masters in Business Administration at Spain’s IE Business School.

Before founding LaGrande Global, Shawn helped manage $1.1 billion in client assets at Bernstein Global Wealth Management. He also worked as a credit research analyst at J.P. Morgan. He is a Certified Divorce Financial Analyst, and he has been an advisor to numerous high-stakes divorce cases.

Shawn is the author of two well-received finance books: Managing Private Wealth: Principles, and Divorce and Your Money: The No-Nonsense Guide, both published in 2016.

In his spare time, Shawn is an ultra-endurance athlete and has competed in events as long as 24 hours. He is an Eagle Scout and a member of the Alumni Board of Greenhill School.