The biggest dilemma in housing is when an owner is under-water on their mortgage.  Let me try to explain why this is such a huge problem.  I’m going to use a situation that a friend of mine is in down in Phoenix Arizona.

In the heat of market in 2006, he bought a home for nearly $420,000.  That home is now worth $180,000.  In the foreseeable future it would be impossible for him to get his equity back in the house.  Meaning, it seems totally illogical that his $180,000 will ever get back to $420,000.  So, what are his options?

Modify His Mortgage:

The problem with a modification is that banks are not reducing principal yet.  Bank of America and Citi have claimed to have started the process, but I will believe it when I see it.  When banks modify loans they typically lower your interest rate and re-amortize your loan.  Meaning that if you are late on your payments they can add the back payments to your loan and essentially will allow you to start over.

Short Sale:

A short sale is typically a very good option in this situation.  The only problem is that he makes to much money to qualify.  His bank has told him repeatedly that his situation will not allow a short sale approval.  He is not in financial hardship.  So at this point, we know he can’t sell his house short and a modification will not do anything to help his situation.

Foreclosure:

In an area like Phoenix, foreclosures are at an all time high.  People are simply giving the keys back to the bank and they are walking away from their home.  This is inevitably what my contact is going to do.  Knowing that he is paying a mortgage on a home once valued at $420,000, he simply can’t stomach continuing to do so.  Especially when his neighbors homes are selling for a third of what he paid for his own home.  His value is $180,000 or less.

His mortgage payment at $420,000 is:   $3,100
His mortgage payment on $180,000 is:  $1,700

So that brings me to my point.  Until the banks start to reduce the principle on their loans they will continue to see this same situation.  Borrowers are well aware that the equity in their homes are gone.  If you were in this position, would you continue to pay the mortgage?  It is a very difficult situation that many borrowers are facing.  What comes first?  Principle reductions from the banks or more foreclosures from the buyers?