An asset or investment is underwater if the market value falls below what the owner paid for it.
The purpose of owning an investment is to earn income from it, sell it in the future at a higher price and perhaps both.
Yet investors who purchase an investment might find that others are unwilling to pay more for that investment later on. The underwater investment must be sold at a loss or held.
Being underwater on an investment is mostly a problem if you are forced by circumstances to sell it for less than you paid, say to raise cash or to pay taxes.
However, income generated by the investment, such as from dividends, interest or rent, is considered part of the investment’s total return. That income offsets the potential loss of a lower market price for the investment itself.
Most people know the term underwater from their experience with residential real estate. Nevertheless, any investment can be described as being underwater.
For instance, options traders use the term to explain the valuation of a contract they hold that would be worthless if it expired that day.
That doesn’t mean the contract is worthless, but it does affect the price. There is no guarantee that the contract will generate a profit before the expiration date arrives, so a potential buyer might be less interested in purchasing it.
A stock or mutual fund investment, meanwhile, would be considered underwater if the market price falls below the price paid.
Nevertheless, many stocks pay a cash dividend every quarter. Investors who buy dividend-paying stocks often take a falling price as a signal to buy more in order to lower the average price paid for a long-term, income-generating investment.
A home that’s underwater can be distressing if the difference is significant. Yet if the homeowner does not intend to move and the cost of the mortgage is not onerous, it usually is better to live in the home and wait for the housing market to recover.
The cost of renting a comparable home could be higher than the combined cost of the mortgage, interest and taxes, for instance. Unlike a renter, a homeowner builds equity in a house by paying the mortgage down steadily, irrespective of the current market value of the property.
For the securities investor, too, being underwater is not necessarily a signal to sell. It can be an opportunity increase a position in a good investment.
If a sale is warranted, however, there still could be a tax advantage. The IRS allows investors to balance losses and gains on their tax return, a practice known as tax-loss harvesting.