Key takeaways

  • Negative equity occurs when your home’s value sinks below the amount you owe on it (from your mortgage or other home loans).
  • Having negative equity can make it difficult to sell or refinance your home.
  • You can’t immediately reverse negative equity, but there are ways to emerge from it: increasing mortgage payments or upgrading your home as you wait for the market to improve.

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 it mean to have negative equity?

Unless you’re buying a house with cash, there are a few steps you’ll need to follow before becoming a homeowner, including applying for a mortgage and making a down payment (generally ranging from 3 to 20 percent of your home’s purchase price). Then, you’ll make a monthly mortgage payment until your home loan is fully paid off (typically within 15 or 30 years).

What we think generally of as home equity (and commonly just call “equity”) is technically positive equity. Essentially, positive equity is the amount of the home you own outright. The amount of your down payment is immediate positive 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. Ideally, your home will also appreciate (increase in value) during this time.

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 you’ve built up in your home and the closer you are to paying off your mortgage.

But if the number is negative/below zero  — if the home appraises for less than what you owe — that would fit the negative equity definition. This can happen during periods of economic downturn or when real estate markets abruptly slow down, causing property values to plummet. As a result, you could end up owing more on your home than it’s worth. Negative equity is sometimes referred to as being underwater or upside-down on a mortgage.

Home Equity
For example, let’s say that your current mortgage loan balance is $360,000. But your home is only worth $300,000. In that case, you would have negative equity of $60,000.

What are the ways negative equity can occur?

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 became upside-down on their mortgages. In fact, the recession had been kicked off by the subprime mortgage crisis of 2006-07, in which widespread defaults on home loans precipitated collapses and crises throughout the financial industry. 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 drop.

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

  • If you make a small down payment (or no down payment at all) and housing prices fall shortly after you move in
  • Falling behind on mortgage payments
  • Borrowing against your equity — for example, by taking out a big home equity loan or home equity line of credit

Why is it important to care about negative equity?

So, what does negative equity mean for you as 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. But if you need to sell your home, it could put you at an economic disadvantage.

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, TX. “To settle the full amount, you might need to touch your savings or sell another valuable asset.”

Home Equity
You might wonder, 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 getting a mortgage, 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 financing. Even so, they’d need to be generous in spirit, or really want your house.

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.

As a homeowner, you should try to avoid a short sale if possible. The lender is taking a loss and so are you — it’s like selling stock shares for less than the price you paid for them. 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.

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.

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.
  • 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 resale value, like additional bathrooms or upgraded ktichens.

What should you do if you have negative equity in your home?

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.

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 and build your home equity. If your lender allows it, you might also consider making additional payments to reduce your loan principal even faster.

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.

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

— Ken SissonRealtor and associate broker, Coldwell Banker Realty

How much negative equity will a bank finance?

For a house? 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 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.

If you’re trying to purchase a new house, you’ll need to take care of the negative equity on your existing home – whether that’s by paying the difference between your mortgage and your home’s value, entering into a short sale, or coming to another agreement with your loan provider.

Final word on negative equity

Negative equity is a situation in which your mortgage balance is higher than your home’s value. If you’re planning to stay in your home and are financially stable enough to continue making mortgage payments, negative equity probably won’t affect you too much. However, negative equity could cause problems if you’re hoping to sell or refinance in the near future.