How to get your mortgage above water

This post comes from Jeff Brown at partner site MainStreet.

The problem: You want to sell your home, but the loan is underwater. To sell now you'd have to dig into other assets to fill the gap between what you owe and what the home will fetch, and you just don't have that much.

The solution? Hope home prices start to recover, continue to make regular payments to steadily reduce the loan balance and either add extra principal payments or save in some other way.

But how long will this take?

It is possible to make an estimate -- to get a sense whether it will take three years or 10, for instance. That should help in evaluating your options, though some key factors are uncertain, such as your home's appreciation rate and the returns you might earn on any savings.

If you want to begin an aggressive effort to get above water, the key issue will be whether to make extra principal payments or to save in another way that might get you to your goal faster but with more risk.

Extra principal payments earn an investment return equal to the mortgage interest rate, since every extra dollar paid to reduce the loan balance saves interest charges on a dollar. (Post continues below.)

If you had a 5% mortgage, extra principal payments would earn a guaranteed 5%, which is high compared with yields on other guaranteed savings. A five-year certificate of deposit, for instance, pays just 1.1%. You might earn more in the stock market, then use the gains to help pay off the loan balance, but you could lose money that way too.

Ordinary mortgage payments also help you slowly get above water because each payment reduces the loan balance. Every payment puts a bit more toward principal than the last.

So how do you put all these factors together? Jack M. Guttentag, emeritus professor of finance at the Wharton School, provides two calculators on his website, The Mortgage Professor. The first shows how long it will take to get above water, the second how much extra one would have to pay on principal to reach a given equity level in a specified time.

His example shows a loan with a $200,000 balance, a home worth $150,000 and a $1,300 monthly payment.

If the loan rate was 6%, the appreciation rate zero and the borrower made only the required payment, it would take 122 months for the negative equity to be wiped out, leaving the borrower with a property worth exactly as much as the remaining loan balance after about 10 years.

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But if the home appreciated at 2% a year and the borrower made extra principal payments of $100 a month, the time to get above water would be cut nearly in half, to 68 months.

Using the calculator, you can study your own situation. Keep in mind that one key factor -- the home's appreciation rate -- is just guesswork, so it will pay to experiment with various rates. It's unlikely we'll see soaring home values anytime soon even if the market does start to recover.

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