The term “underwater” finds extensive use in the world of finance. It generally categorizes situations where the value of an asset or investment is less than its corresponding liability or evaluation.
Financial Contexts of Being ‘Underwater’
1. Loans and Mortgages
Underwater Loans / Mortgages
An underwater loan or mortgage refers to a situation where the remaining balance of the loan exceeds the value of the collateral. This is often seen in mortgage finance when the market value of the property declines significantly.
For example, if a homeowner owes $300,000 on a mortgage, but the home is now worth $250,000, the mortgage is considered to be underwater. This condition can lead to financial strain and difficult decisions for property owners.
Relevant Concepts
- Lien - A legal right to keep possession of property belonging to another person until a debt owed by that person is discharged.
- Negative Equity - Occurs when the value of an asset is less than the outstanding balance on the loan used to purchase that asset.
2. Options Trading
Underwater Options
In options trading, being underwater refers to a scenario where the exercise price (strike price) of an option is higher than the market price of the underlying stock.
For instance, consider a call option with a strike price of $50. If the market price of the stock is $40, the option is underwater, meaning it currently holds no intrinsic value.
Key Terms
- Exercise Price (Strike Price): The specified price at which an option can be exercised.
- Intrinsic Value: The difference between the underlying asset’s current market price and the exercise price of an option.
3. Investment Portfolios
Underwater Portfolios
When an investor’s portfolio of stocks or bonds is losing value from its initial purchase cost, it can be described as being underwater.
For example, if an investor’s portfolio was valued at $100,000 and it drops to $80,000, this signifies a loss, thereby placing the portfolio underwater.
Key Elements
- Market Value: The current quoted price at which an asset or service can be bought or sold.
- Unrealized Loss: The potential loss of currently held investments which have not yet been sold to realize the loss.
Examples and Historical Context
Example Scenarios
- Real Estate Example: A homeowner bought a property at $400,000 with a loan of $350,000. If the property’s value drops to $300,000, the loan becomes underwater.
- Stock Options: An employee stock option plan includes options at $30 per share. If the current market price is $25 per share, the options are underwater.
Historical Context
The term “underwater” became widely used during the 2007-2008 financial crisis, particularly in the real estate sector. During this period, housing prices plummeted, and many homeowners found their mortgages to be worth more than the market value of their homes. This led to increased foreclosures and a realization of economic instability.
Related Terms
- Upside-Down Mortgage: Another term for an underwater mortgage where the loan amount is higher than the home’s market value.
- At-the-Money: An option where the exercise price is the same as the market price of the underlying asset.
- In-the-Money: An option that would lead to a positive cash flow if exercised.
FAQs
How can a homeowner handle an underwater mortgage?
Can underwater stock options become valuable again?
What is the impact of an underwater investment portfolio on financial planning?
References
- Investopedia. “Underwater Mortgage Definition.” Investopedia.
- NASDAQ. “What happens when stock options go underwater?” NASDAQ.
Summary
The term “underwater” encompasses various financial predicaments where liabilities or performance exceed asset values or benchmarks. Understanding its implications in loans, mortgages, options, and investment portfolios is key to managing financial health and making informed decisions. As financial landscapes shift, the concept of being underwater remains crucial for both individuals and institutions to navigate effectively.
