What Is Negative Equity?
Negative equity occurs when the value of real estate property falls below the outstanding balance on the mortgage used to purchase that property. Negative equity is calculated simply by taking the current market value of the property and subtracting the amount remaining on the mortgage.
key takeaways
- Negative equity occurs when the value of real estate property falls below the outstanding balance on the mortgage used to purchase that property.
- Negative equity is colloquially referred to as "being underwater."
- Negative equity often results with the bursting of a housing bubble, a recession, or a depression—anything that causes real estate values to fall.
How Negative Equity Works
To understand negative equity, we'll start by explaining positive equity, also known simply as home equity.
Home equity is the value of a homeowner’s interest in their home. It is the property’s current market value less any liens or encumbrances attached to the property.This value fluctuates over time as payments are made on the mortgage and market forces play on the current value of that property.
If some or all of a home is purchased using a mortgage, the lending institution has an interest in the home until the loan obligation is met. Home equity is the portion of a home's current value that the owner possesses free and clear.
Home equity can be accumulated by either a down payment made during the initial purchase of the property or with mortgage payments, as a contracted portion of that payment will be assigned to bring down the outstanding principal still owed. Owners can benefit from property value appreciation as it causes their equity value to increase.
When the opposite happens—when the current market value of a home falls below the amount the property owner owes on their mortgage—that owner is then classified as
having negative equity in the home. The sale of a home with negative equity becomes a debt to the seller, since they would be liable to their lending institution for the difference between the attached mortgage and the sale of the home.
Negative Equity's Economic Implications
Negative equity can occur when a homeowner purchases a house using a
mortgage before either the collapse of a housing bubble, a recession, or a
depression—anything that causes real estate values to fall. For instance, say a buyer financed the purchase of a $400,000 home with a mortgage of $350,000. If the market value of that home the following year tumbles to $275,000, the owner has negative equity in the home because the mortgage attached to the property is $75,000 greater than what it would sell for in the current market.
In real estate jargon, If the outstanding dollar amount remaining on the mortgage is larger than what the home is worth, the property, the mortgage, and the homeowner are said to be underwater.
Underwater mortgages were a common problem among homeowners around the height of the financial crisis of 2007-2008 which, among other things, involved a substantial deflation in housing prices. As the subsequent onset of the Great Recession proved, the widespread epidemic of negative equity across the housing market can have far-reaching implications for the economy as a whole. Homeowners with negative equity found it more difficult to actively pursue work in other areas or states due to the potential losses incurred from the sale of their homes.
Special Considerations
Negative equity is not to be confused with mortgage equity withdrawal (MEW), which is the removal of home equity through a loan against the property's market value. A mortgage equity withdrawal reduces the real value of a property by the number of new liabilities against it—but it doesn't mean the owner has gone into the red, equity-wise.
How can you avoid negative equity?
If you're buying a home, purchase a property you can truly afford and put down a larger payment upfront. Once you're in the home, make up grades that add to your home's value.
What are the implications of negative equity?
Having negative equity on your home can be a big source of financial distress that can make it difficult to sell your home or obtain future financing.
How can I tell if I have negative equity?
Start by finding out your home's current market value. Then, check your mortgage statement to learn how much of a balance you still owe. Subtract the balance from the value to figure out how much equity you have (positive or negative).
The Bottom Line
If you're underwater with your mortgage, it typically means that you have negative equity. This means your real estate value has fallen between the balance on your mortgage, which can happen after a housing bubble bursts, a recession, or a depression. Negative equity can make it challenging to sell your home.
