Negative equity occurs when the value of a real estate property falls below the outstanding balance on the mortgage used to purchase the property. It is calculated by subtracting the amount remaining on the mortgage from the current market value of the property.
Key Takeaways
- Negative equity happens when the value of real estate property is less than the outstanding mortgage balance.
- This situation is often referred to as ‘being underwater.’
- Negative equity commonly results from the bursting of a housing bubble, a recession, or any economic downturn that causes real estate values to fall.
How Negative Equity Works
To understand negative equity, we must first understand “positive equity,” commonly referred to as home equity.
Home equity is the value of a homeowner’s interest in their home. It is the property’s current market value minus any liens or encumbrances attached to that property. This value changes over time as payments are made on the mortgage and market forces affect the property’s current value.
If a home is purchased through a mortgage, the lending institution has an interest in the home until the loan obligation is satisfied. Home equity is the portion of a home’s current value that the owner holds free and clear.
Home equity can be accumulated via a down payment made during the initial purchase of the property or with mortgage payments. Part of these payments go toward paying down the outstanding principal. Owners can also benefit from property value appreciation, which will increase their equity.
When the opposite happens—when the current market value of a home falls below what the owner owes on their mortgage—the owner has negative equity. Selling a home with negative equity turns into a debt for the seller, who would be liable to their lending institution for the difference between the attached mortgage and the sale price of the home.
Negative Equity’s Economic Implications
Negative equity can occur if a homeowner purchases a house using a mortgage before a housing bubble bursts, a recession hits, or any event that causes real estate values to drop. For instance, if a buyer finances a $400,000 home with a $350,000 mortgage, and the next year the market value of the home drops to $275,000, the owner now has negative equity. The mortgage balance is $75,000 more than the current market value of the home.
In real estate jargon, if the outstanding mortgage balance is larger than the home’s worth, the property, mortgage, and homeowner are said to be ‘underwater.’
Underwater mortgages were a common problem during the height of the financial crisis of 2007-2008, which involved a substantial deflation in housing prices. The Great Recession demonstrated that widespread negative equity can have far-reaching impacts on the overall economy. Homeowners with negative equity found it challenging to move for work due to potential losses from the sale of their homes.
Special Considerations
Negative equity should not be confused with mortgage equity withdrawal (MEW). This is the removal of equity from a home’s value through a loan against the property’s market value. Mortgage equity withdrawal reduces the property’s real value by the new liabilities against it but doesn’t mean the owner has negative equity.
Related Terms: positive equity, home equity, underwater mortgage, housing bubble, recession.
References
- Reverse Mortgage. “What Is Home Equity?”
- U.S. Department of Housing and Urban Development. “Negative Equity in the United States”.
- U.S. Department of Housing and Urban Development. “Tips for Dealing with an Underwater Mortgage”.
