What does Underwater mean in Finance?
“Underwater" refers to a financial situation where the value of a financial contract or asset is worth less than the remaining loan amount on it. Simply put, an asset is considered underwater when the loan amount is greater than the current value of the asset. This can happen commonly with mortgages, where a decline in property values leaves the homeowner owing more on the loan than the house is worth. For example, you bought a house for ₹40 lakh on a loan. Over time, property prices decline due to economic reasons, and the house's value drops to ₹32 lakh, while you still owe ₹35 lakh on the loan. If you decide to sell the house to pay off the debt, the sale proceeds will not be sufficient to cover the remaining loan amount. It's a challenging situation that many people find themselves in, and it's crucial to understand the concept of being 'underwater' in finance.
Underwater Explained
An asset is considered underwater when its current value falls below the original purchase price. This essentially means you’re holding onto a loss, though it hasn’t been realized yet (on paper).
The term “underwater” is especially common when dealing with leverage or borrowing money to invest. In this scenario, you own an asset with a loan against it, but the asset’s worth dips lower than the loan amount.
For a better understanding, let’s take the example of a stock trader who used a margin account to buy stocks. If the company goes bankrupt and the stocks he is holding are not enough to cover the loan taken from the broker, the margin account will be underwater, and the trader will face a margin call—a demand to deposit more funds to cover the shortfall or sell the stock at a loss to repay the loan.