Negative equity is when your outstanding mortgage balance is more than the current value of your home. This happens when the value of your property has fallen due to a change in the housing market, or if you’re in the early years of paying off your mortgage and haven’t made a large down payment.
Negative equity may not be an issue for many homeowners right now, especially after the last two years record high housing pricesbut it can happen under certain market conditions – and when it does, it can have significant financial consequences for the homeowner.
Here’s what you need to know about the negative equity and how to avoid it.
Why does negative equity occur?
Negative equity can result from factors beyond the homeowner’s control, such as downturns in the housing market or economic slowdown. Words and phrases like “underwater” and “being upside down on your mortgage” are synonymous with the fact that you owe the bank more than what your home is worth.
You can also suffer from negative equity if you haven’t made a big down payment and it’s been a few years paying off your mortgagebecause most of your monthly payment amount goes towards paying the interest, not the principal amount of your mortgage.
How does negative equity work?
Let’s say you bought your house five years ago for $400,000 and made a $35,000 down payment on a 30-year, 5% fixed-rate mortgage. You’ve been paying your mortgage monthly for the past five years, paying off $11,500 of your principal. That leaves $353,500 owed to the lender. If the home’s value remains at $400,000, you now have $46,500 in “positive” equity.
However, if real estate values somehow crash and your home is valued at less than, say, $340,000, then you’ll end up with negative equity because that $353,500 owed on the mortgage, are higher than the last value of the property.
Equity = Current Value – Outstanding Debt
Equity = $340,000 – $353,500 = -$13,500 (negative equity)
Even if the value of your home goes down and you have negative equity, you are still responsible for paying the full amount of your mortgage to your lender.
The disadvantages of negative equity
Your biggest financial investment has lost value: For many homeowners, a home is the most expensive purchase they’ll make in their lifetime, and it’s a reliable way to build wealth over time. But when the value of the home falls below the value of the mortgage, the net worth also falls. Your largest asset now has a negative value.
No access to home loans: Negative equity also means you have no equity to borrow against your home. With no equity to borrow from, lenders won’t approve you for a housing loan, home equity line of creditor any type of financing that relies on your home as collateral.
Moving to another home may not be an option: The average homeowner must sell their home to move to another. But if you sell your home when it’s worth less than what you paid for, you’ll owe the bank money instead of benefiting from the sale—and the lender won’t stop selling your home until you pay it back in full.
How to prevent negative equity
While you can’t predict which way the market will go, you can make smart decisions about how you will pay for your home and the location and time of purchase. Consider waiting for the peak of the housing market if you get into bidding wars or need to make offers on the spot. Remember that the housing market is cyclical, so you may be just a few years away from more affordable housing options.
Make as large a down payment as possible: Making a large down payment is the fastest way to build equity in your home. Making a larger down payment means you have more equity to access from the very beginning of paying off your mortgage.
Don’t buy a home when prices are skyrocketing: Although many people struggled to buy houses during the pandemic, they bought at the top of the market and paid a premium for those properties. As the housing market continues to correct and home prices slowly continue to fall, these homes lose some of their value. Consider buying a house that is expected to appreciate in value rather than one that has already reached its peak value.
Buy at an established location: Some regional housing markets are at greater risk of losing value than others. For example, cities that became pandemic hotspots, such as Boise, Idaho, had some of the biggest gains in home sales over the past two years, but are now losing value faster than more established markets such as New York and Boston, where people still desire to live, as regular work and school schedules fall back into place.
Buy a house you can afford: Don’t let your eyes get bigger than your wallet. If your mortgage payments are too expensive and you fall behind, you can also end up with negative equity as well as putting yourself at risk of foreclosure.
The bottom row
The easiest way to avoid the negative equity is to make a large down payment when buying your home. If that’s not possible, be strategic about when and where you buy a house. Avoid buying a house at the top of the market when home values are likely to fall in the near future. Also, consider purchasing a location that has proven consistently desirable to homeowners.
