Q: My husband and I are underwater on our lovely historic 1930 era home, which we hoped to grow old in. We paid $783,000 for it back in 2005, when we had a six figure income as a couple and could afford it. Our home is now worth about $500,000. What should we do?

A: You are in a very, very tough and complex situation because based on everything you’ve said to me via our coaching call. Here are the facts:
•    Your husband has been put of work since March 2008 and receives his last unemployment check (after four extensions) this month.
•    You’ve repeatedly sought a loan modification, since December 2008, from your lender but have been consistently rejected because you are current with your payments
•    You’ve already depleted your savings from $25,000 to about $9,000
•    You have roughly $25,000 in credit card debt
•    You’ve been advised by a lawyer and a loan modification company to stop making payments, attempt a short sale, and if that fails file bankruptcy or go into foreclosure
•    You cherish your home and neighborhood and really don’t want to leave there
•    You and your husband both have very good credit scores in the 700s. Your credit score is 762, and you want to maintain a good credit rating

The Perfect Storm

It sounds like you and your husband have been caught in the middle a “perfect storm” financially speaking. Not only are you seriously underwater in your home – as are 1 out of 4 homeowners nationwide – but you are also grappling with a serious loss of income, due to your husband being out of work for nearly two years. Moreover, the credit card bills are mounting and the savings you’ve amassed are quickly dwindling.

Obviously, you have been able to hang on until now, using your individual job earnings and your collective savings as a way to stay afloat. But I recognize that you’re in desperate need of a life jacket – and soon.

Tough Choices Ahead

You did not say how old you are, but you did indicate that you would have liked to “grow old” in your current house. So I sense not only how passionately you love your home, but also your willingness to stay put for many more decades. If that it the case, then you have to make some difficult choices. The first is whether or not you’re willing to sacrifice your credit rating in the short term, in order to achieve a long-term objective, namely saving your home.

Currently, your mortgage balance appears to exceed the value of your home by 50% or more. Realistically speaking, it could be another 10 or 20 years before your home regains it value. Who knows? This makes any potential sale highly unlikely – at least without doing damage to your credit report, as a short-sale will definitely do. A short-sale, foreclosure, or a deed-in-lieu-of-foreclosure are all treated the same for the purposes of your credit rating. They are major negative events that will cause a triple-digit decline in your FICO credit scores.

But in my opinion, a short sale is not the best option for you – certainly not at this time. Because your home is so deeply underwater, you may have difficulty finding a buyer. And even if you do, it’s likely that you lender will balk at agreeing to such a low price. No matter what the market value of the home really is, the bank may reject your short sale deal because it may result in a potential loss of a few hundred thousand dollars for your lender.

Don’t Succumb to a Short-Sale, Foreclosure or Bankruptcy

As I said, however, it’s a little premature for a short-sale – primarily because you adore your home, you want to stay in your neighborhood, and you have actually been able to make the payments (as hard as that’s been).

Given all of your circumstances, I do think the attorney and the loan modification company were correct about one thing: if you really want to get your loan adjusted, unfortunately you will have to miss payments. Yes, this will cause damage to your credit rating. But the damage of having a 90-day late payment on your home will be a single, isolated event. It will be far less harmful than bankruptcy (which will stay on your credit report for 10 years) or foreclosure, which will also haunt you for seven years, and means that you’ve lost the home you treasured.

Contain the Fallout to Late Mortgage Payments

Instead of bankruptcy, foreclosure or a short sale, try to contain the damage to just being 90-days late on your mortgage. Keep up those credit card payments; even if you’re only making minimum payments, and you will be able to rebound, from a credit standpoint, from the late mortgage payments.

It’s a kooky system we’re dealing with now. But the sad truth is that so many homeowners are struggling with payments that banks are “prioritizing” and only offering help to the “neediest” of borrowers – i.e. those that are already behind of their home payments. Ironically, although you and your husband are trying to be responsible and do the right thing by staying current, your fiscally responsible behavior is the very thing standing in the way of you getting a loan modification.

Ask for a Trial Modification

So the bottom line is this: I hate to have to offer this recommendation, but if you really want to stay in the home, or even just buy your family a bit of time until your husband can get a replacement job, then you should first find out all the details you can about your lender’s home loan modification program.

Get all the paperwork, applications, and other forms you can – even ahead of actually missing a payment. Once you are late on your mortgage, many lenders offer you the opportunity to go through a “trial” modification period. That’s where you make reduced payments – usually for three or six months in a row – to show the bank that you can afford the modified mortgage amount.

Again, I know this isn’t an ideal situation. But in your situation, you can not achieve all the objectives you want simultaneously. Think about the long-term. If you truly want to stay in the home, and if you and your husband can afford it with a modified mortgage, then don’t be so stressed by the fact that the home is underwater. After all, if things work out, then your equity “loss” really mainly matters on paper, because you’ll never sell that home you love so much anyway – not now, and not in the future.