What to do if you're underwater on your mortgage

House floating on blue water

Here's a dilemma facing an estimated 11 million homeowners, or more than one out of every five mortgage holders.

They owe more on their mortgages than their homes are worth.

That's what happens when home prices decline by one-third since 2006, wiping out about half of all the equity we had in our homes, according to the Federal Reserve.

What you should do about that depends on everything from how far underwater you are to whether you have enough money to keep up with the payments.

Here are the five options all homeowners in this situation have, along with some suggestions on which one might be the most appropriate for your situation.

Let's start with the one that's right for most underwater homeowners…

Option 1. Ride it out and do nothing.

If you can make the monthly payments and don't have to move, the smartest thing to do is to just stay put.

You have to live somewhere, and this is the least costly, least risky course of action until you see what happens to the housing market in your area.

If you only owe 10% more than your home is worth, there's a fair chance you'll be back in the black in three to five years.

If you owe 20% more than your home is worth, it will probably take a little longer. Think five to 10 years.

That doesn't sound too good, but it's today's reality. Experts say we could be in for another couple of years of declines in the housing market. So it may get worse before it gets better.

The long-term historical average annual growth of real estate is about 3%. So, if the housing market is really at its bottom, you might be back in the red in four to five years.

Of course, all of this can vary by location.

Your borrowing will also likely be limited by the fact that you are underwater. Don't plan on getting a second mortgage or home equity loan anytime soon.

Option 2. Refinance through a government program.

You can't afford to wait and see if you're struggling to make your payments.

With interest rates at record lows this winter, most homeowners can lower their payments by refinancing their loans.

But lenders won't do that when you owe more than your home is worth unless you can qualify for help from the government.

There are two options you should consider.

The first is the Home Affordable Refinance Program (HARP), which was originally supposed to help 5 million borrowers qualify for cheaper loans.

But by last fall, only 900,000 homes had been refinanced through the program because homeowners weren't allowed to borrow more than 125% of the value of their homes.

That led President Barack Obama to scrap the cap. You can now apply for a new loan no matter how much you owe or what your home is currently worth.

CoreLogic, which analyzes loan data, estimated that will open HARP up to about 4.7 million of the 11 million borrowers who are underwater.

Click here to learn more about how the Home Affordable Refinance Program has been changed to help more homeowners.

The second option is to refinance through the Federal Housing Administration.

Some of its refi programs will rewrite your loan regardless of how much -- or how little -- equity you may have.

Some borrowers may also find it easier to obtain an FHA loan because you can have lower credit scores and more debt than non-FHA loans allow.

In some instances, you can even qualify if you're currently unemployed -- something that's impossible to do anywhere else.

Click here to learn more about FHA refinancing programs.

Option 3. Ask your lender for a short sale.

If you have to move or want out from under the burden of a home that will never be worth what you paid for it, ask your lender about a short sale.

A short sale is when the lender agrees to accept a sales price on the property of less than you owe and forgives the remaining debt.

Lenders are only willing to do this when they'll lose less money than they would if you default and they must foreclose on a property.

Short sales are always a long, arduous process. You'll need a real estate agent and attorney to help you see it through to a successful conclusion.

Our 7 steps to completing a short sale will show you want to expect and the decisions you'll have to make.

Be aware that a short sale will really hurt your credit. In most cases, it will show up on your credit as preforeclosure or redemption status and can result in a dip of 100 to 300 points.

If you didn't miss any payments and managed to do a short sale, you might get lucky and buy another home immediately.

But if you did miss payments and had a short sale, you could have to wait up to two years or more to buy another home.

Finally, there could also be tax ramifications in the "loan forgiveness" that the bank may grant you.

If you had a $230,000 loan, the bank let you sell the house for $200,000 and forgave that $30,000, you could owe taxes on that difference.

Option 4. Rent it out.

If you need to move, renting could be an option.

This is never an easy option. There's a lot more to it than you think, both legally and financially. And, it can be a real pain.

You'll likely need to consult a lawyer or accountant and will need a new insurance policy on the property.

You'll also need to establish a market rental rate that covers the loan, insurance, taxes, legal costs and property management fees.

You may not find a tenant willing to pay as much as you'd like, but if your only option is letting the house sit vacant, some rent is better than no rent.

You cannot discriminate on the basis of race, religion or sexual orientation, but you can and should use credit checks, background checks and references.

Check our 8 steps on how to rent your hard-to-sell home to get a sense of everything you must do – and all the potential pitfalls.

Option 5. Walk away.

It's pretty serious if you are underwater by 20% or more.

No matter how you look at it, making the payments on a $300,000 mortgage for a home that's only worth $200,000 doesn't make much financial sense.

It's even worse if you're stretching to make the payments.

There are so many other ways you could use the money you're pouring into your home more profitably.

Walking away from your home is a tough thing to do, but like amputating a limb to save a person's life, it might be the only choice.

You have to question whether it's best to spend the next decade trying to recoup that 30% lost equity in your home or if you should make a break for a fresh start.

More homeowners have been taking this road in the past few years. “Strategic default” is where a homeowner stops paying the loan even though they can afford the payment.

A recent study at the University of Chicago found that in 2010, 30% of strategic defaults were by homeowners who could afford the payments.

The idea is that you intentionally stop paying your mortgage to strong-arm the bank into reducing principle or letting you do a short sale.

In some cases it works, but in many cases it leads to foreclosure. Since the house is the collateral on the loan, there is often little the bank can do after it takes your home.

If you do decide to go this route, you'll first want to consult an attorney because there will be serious consequences if you default.

Your credit will take a major hit, and the bank may try to come after you for the remaining balance.

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