A borrower has negative equity when they owe more on their mortgage than their home is worth. It often occurs when the home’s market value drops due to regional or larger real estate trends and economic shifts. The amount of negative equity is essentially the difference between the amount owed on the home and its current market value.
Negative equity can be worrisome, but there are ways to survive owning a home with negative equity. We’ll take a closer look at what negative equity is, how it works, and how to avoid getting into a negative-equity situation.
Definition of Negative Equity
Equity is how much value you have in your home, or the current market value of the home minus any outstanding debt, like a mortgage loan. When this formula yields a negative number, you have negative equity. In other words, if you were to sell the home for its current market value, you’d actually owe the bank money to close out the mortgage.
- Alternate name: underwater on a mortgage loan, upside-down loan
How Does Negative Equity Work?
Let’s say you purchase a $315,000 home with a $300,000 mortgage and a down payment of $15,000. Five years into your 30-year loan, you’ve paid $6,000 of the loan’s principal. You owe the lender $294,000 in principal, and if your home is still worth $315,000, you have $21,000 in (positive) equity.
But if, on the other hand, real estate values have decreased and comparable homes are selling for $270,000, you have negative equity. The calculation for equity is:
Equity = Current Value - Outstanding Debt
Equity = $270,000 - $293,000 = -$23,000
As you can see, your equity would be negative $23,000 (-$23,000) at this point. If, on the other hand, your home had grown more desirable in the market and someone would buy the house for $350,000, you’d have positive equity of $57,000.
Factors That Lead to Negative Equity
Many factors can cause a house’s value to diminish, but there are some circumstances that make a negative-equity situation more likely:
- You made a low—or no—down payment on your mortgage loan.
- You are in the first couple of years of the mortgage loan when the portion of your payment going toward principal is lowest.
In these situations, you simply don’t have a lot of positive home equity to work with, which means even small changes in the market value of your home could result in negative equity.
How to Prevent Negative Equity
While you may not be able to influence the larger real estate market, there are actions you can take to prevent negative equity or mitigate a current negative-equity situation.
Wait It Out
If you wait out a negative-equity situation, paying down the loan can rebuild equity as your principal payments reduce the amount you owe on the loan. Also, since real estate markets tend to be cyclical, your home might ultimately regain value if you’re in a position to wait long enough.
Deposit a Larger Down Payment
If you buy your home with a reasonable down payment, you may be less likely to develop negative equity. In the example above, if the homeowner purchased their $315,000 home with a 20% down payment of $63,000, their loan amount would be $252,000. Even if the market brought the home’s value down to $270,000, they’d still have $18,000 of positive equity.
This is not to say that every home should have a large down payment or that having negative equity is the worst situation to be in. In fact, if you purchase a home with a down payment, you’re “depositing,” so to speak, that amount into your home. If your home then loses value, you’ve lost some or all of that amount.
It’s true that you’d have to pay the rest of your debt out of pocket should you want to sell in a down market, but you have the option to wait it out.
If you choose to sell with negative equity, the bank will require that you pay the remaining balance on the mortgage loan.
Drawbacks of Negative Equity
Though negative equity may not always be the worst situation, it does have significant drawbacks:
- Your home, which may be your biggest investment, has lost value: For many people, their home is their biggest asset. Having negative equity literally means its value has diminished.
- Home equity loans are not available: With negative equity, you’re not eligible for home equity loans and home equity lines of credit (HELOCs) to finance home improvements or to use for other purposes.
- Moving to another home or location may not be an option: If you want to move, you may feel trapped by your mortgage if you have negative equity—especially if you can’t afford to pay the bank the difference between what the home is worth and what you owe on it.
- May increase the likelihood that you default on the mortgage: According to HUD’s Office of Policy Development and Research, people with loan-to-value ratios higher than 80% are much more likely to default on their loans.
- Negative equity occurs when your home’s value is lower than the balance on your mortgage loan.
- There are multiple factors that can cause negative equity, such as a sluggish or declining real estate market, especially if the down payment on the home was minimal.
- Negative equity can resolve itself when the market improves and/or if you continue to pay down a mortgage loan.
- Despite having negative equity, borrowers still owe the full value of the loan to the lender and may need to pay off the balance of the loan if they sell in a depressed real estate market.