What Is Negative Equity And How Does It Happen?

When you buy a home, you expect it to increase in value over time. But what if it does the opposite? If it depreciates, you might end up being in a state of negative equity. Let’s look at how this condition — aka being upside down or underwater — might occur and what you can do if it does.

What does negative equity mean?

Negative equity means your home is worth less than the outstanding balance on your mortgage, and/or any other debt attached to it.

What we think of as home equity (and commonly just call “equity”) is the difference between your home’s market value and the amount owed on it. It represents the amount of the home you own outright, free and clear of the mortgage or other home-secured loan.

When you buy a home, the amount of your down payment is immediate equity in the home. Then, as you make mortgage payments, your ownership stake — aka your equity — in the home gets larger each month, and your lender’s gets smaller. An increase in property/real estate market values overall will also elevate your individual home’s worth, and this appreciation also augments your equity stake.

Home equity is determined by taking the appraised value of your property and subtracting your outstanding mortgage balance. The higher it is, the more positive equity it represents. But say the number works out to be below zero: Your home appraises for less than your mortgage balance.

As a result, you end up owing more on your home than it’s worth, and the value of your ownership stake is nil. You have negative equity, also referred to as being underwater or upside-down on a mortgage.

How to calculate negative equity

To figure out if your home is in negative equity, start by determining the current market value of your property. Then, check your latest mortgage statement to find your remaining balance. Subtract it from your home’s value, and that, roughly, is the amount of equity you possess.

Causes of negative equity

You could end up underwater for several reasons, ranging from economic shifts to individual choices.

Economic downturns

Widespread negative equity is typically the result of a significant economic disturbance, like a recession or depression, or an abrupt bursting of a housing bubble (a sharp, speculative spiraling of home prices). When property values decreased by one-third during the Great Recession, for example, many homeowners across the U.S. became upside-down on their mortgages. In fact, the recession had been kicked off by real estate: the subprime mortgage crisis of 2006-07, in which widespread defaults on home loans precipitated problems throughout the financial industry and eventually the economy. Though the Great Recession technically lasted until 2009, it took several more years for residential real estate values to fully recover from their 33 percent plunge.

Housing market depressions or recessions can also happen on a more local level, throughout a state or a city, if there’s a blow to the regional economy or a natural disaster that hurts property values.

Personal financial choices

On an individual level, there are several scenarios in which negative equity can occur, including:

• Making a small down payment (or no down payment at all) and housing prices fall, even modestly, shortly after you move in. For example, if you put only 10 percent down, and property values drop 5 percent, you have lost 50 percent of your equity.
• Paying an extremely elevated sales price (say, at the height of the market)
• Falling behind on mortgage payments, and accumulating interest and penalties
• Borrowing against your equity — for example, by taking out a big home equity loan or home equity line of credit — and then experiencing a drop in property values

Impact of negative equity

So, what does negative equity mean for a homeowner? Scary as it sounds, it might actually mean nothing. “For the most part, negative equity isn’t necessarily a bad thing, as long as you’re not planning on selling or refinancing the home in the near future,” says Ken Sisson, a Los Angeles-based Realtor and associate broker with Coldwell Banker Realty in Studio City, Calif.

If you’re going to stay in your home long-term and can keep making your full mortgage payments on-time, negative equity shouldn’t impact your credit or affect your finances in any way, really. It’s a paper loss — and n fact, you might not even notice it.

But if you need to sell your home, it could put you at an economic disadvantage.

If you want to sell

When a home changes hands, the old homeowner must pay off their current mortgage, and most people need the proceeds from the sale to do so. But with negative equity, you’ll fall short.  “In that case, the amount you’ll get from selling your property won’t be enough to meet your mortgage payments, and you will have to pay back the additional balance on the mortgage,” says Brady Bridges, broker/owner of Reside Real Estate in Fort Worth, Tex.

If you can’t afford to pay the difference between your current home value and remaining mortgage balance, you may need to ask your lender if they’ll consider a short sale. Under this arrangement, you’ll sell your home for whatever it’ll fetch and put the money toward your mortgage (even though it won’t cover the entire home loan). Then, your loan provider forgives the remaining balance.

Even though you won’t be in debt to your lender, a short sale can hurt your credit score and doesn’t let you realize any profit from your home sale. Also, they are not easy or quick to arrange, and could add months to the time it takes to sell your home.

If you want to borrow more

If you’re underwater, refinancing is also challenging because lenders usually won’t let you borrow money without any equity in your home. And of course you can forget about taking out home equity loans, HELOCs or any other house-secured debt. Instead, you may need to wait until your home value increases or until you’ve re-paid enough of your loan to reach positive equity again.

Negative equity isn’t necessarily a bad thing, as long as you’re not planning on selling or refinancing in the near future.

— Ken Sisson
Realtor and associate broker, Coldwell Banker Realty

How to avoid negative equity

Going into negative equity isn’t always within your control (you can’t predict the ups and downs of the local real estate scene, after all), but there are some ways to protect yourself from it. Here are a few strategies to avoid going underwater:

• When buying a home, shop within your budget, and don’t take on a bigger mortgage than you can afford or really need.
• Make a larger down payment to get a bigger slice of equity upfront.
• Prepay your mortgage to build equity more quickly.
• Invest in your home, with strategic renovation projects that will increase its market value, like additional bathrooms or an upgraded  kitchen.

How to manage negative equity

Unfortunately, you can’t immediately reverse negative equity — not without some windfall that lets you immediately settle your mortgage, anyway. But there are ways to get out of it slowly.

Ride out the market

The most straightforward option is to ride out the market downturn until property values rise again (real estate does tend to appreciate in the long run). Continue to make mortgage payments, reducing your debt and increasing your ownership stake.

Pay down your mortgage faster

If your lender allows it — and you can afford it — you consider making additional payments to reduce your loan principal even faster, or bigger payments each month (make sure the extra money goes toward the loan principal, not just the interest).

Enhance your property value

While you’re doing that, you can also work it from the opposite end, by enhancing your property value. You don’t want to incur a lot of fresh debt, of course, but there are a lot of improvements that are fairly low in cost but big in ROI (return on investment): installing or repairing hardwood floors, upgrading garage or front doors, swapping out your old appliances, and sprucing up your outdoor spaces are all great ways to boost the appeal and monetary value of your property.

At the very least, invest in regular maintenance and upkeep. Unless it’s a super-hot seller’s market, the shoddy condition of an individual home can cancel out a general appreciation in home prices.

FAQ about negative equity

• Can I sell a home with negative equity?
  

  If you’re underwater, wouldn’t it be possible to sell your home for a huge amount that’ll make you whole again, enough to pay off the mortgage? It’s possible — but not likely. If your buyer is financing the purchase, their lender is only going to loan them a sum based on your home’s current market value; price the home too much higher, and you’ll fall into an appraisal gap. The strategy could only work if a) you’re underwater by only a few thousand dollars or b) you sell to an all-cash buyer, who doesn’t need a mortgage. Even so, they’d have to be generous in spirit, or really want your house.

• How much negative equity will a bank finance?
  

  For a home? Basically, none. When you have negative equity in your car, some dealerships will allow you to roll it into your new car loan —but that’s not the case with houses and home equity. Since banks generally won’t lend you more than your home is worth, you often can’t refinance an underwater mortgage. Instead, you’ll need to wait until you’ve built up positive home equity.

• Does negative equity hurt your credit?
  

  Just having a home with negative equity doesn’t necessarily mean you have hurt your credit. In fact, it shouldn’t influence your credit score at all, if your mortgage payments and any other loans associated with your home are up to date. That score will only be hurt if you fall behind in your mortgage or other home loan payments — or your other bills, of course. However, if you’re applying for new financing, or having to file a net-worth statement for some purpose, negative equity could make you seem less creditworthy in a general way, in the proportion of your debts to your assets.

• Does negative equity lead to foreclosure?
  

  Negative equity doesn’t necessarily lead to foreclosure, which happens when a mortgage lender seizes control of a property because the borrower has defaulted on repaying the loan. Default means missing multiple payments, typically over a 120-day period. In fact, a Federal Reserve Bank of Boston study found that the overwhelming majority of negative equity households don’t lose their homes. However, negative equity can lead or contribute to foreclosure, if the same economic conditions (like a recession) that decreased the home’s value are also hurting income or making payments insupportable.  It can also prevent you from qualifying for a loan modification or forbearance from your lender, leaving you no choice but a short sale of your home (selling it for less than the outstanding mortgage, with your lender’s permission).

Additional reporting by Maya Dollarhide