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 with negative equity in your home. Let’s look at  how this might occur and what you can do if it does.

Home Equity
Key Takeaways
  • Negative equity occurs when your home’s value sinks below the amount you owe on your mortgage.
  • 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: maintaining or improving your home’s condition as you wait for the market to improve.

What is 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 (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).

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.

Unfortunately, this scenario doesn’t always happen. During periods of economic downturn or when housing bubbles burst, property values can plummet. As a result, you could end up owing more on your home than it’s worth. This is known as having negative equity in your home.

Home Equity
For example, let’s say that your current mortgage loan balance is $360,000, but because of a recent dip in the local real estate market, your home is only worth $300,000. In that case, you would have negative equity of $60,000.

What is “positive equity”?

What we think generally of as home equity (and commonly just call “equity”) is technically known as 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, it increases to the amount that you’ve paid off on your mortgage, representing the value of your interest in your home (as opposed to your lender’s).

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 be considered negative equity. Negative equity is sometimes referred to as being underwater or upside-down mortgage.

Why is it important to care about negative equity?

It’s smart to pay attention to changes in the market and how they can affect your assets. However, depending on your future plans for your home, negative equity isn’t always a cause for panic.

“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, CA.

But what if you are thinking about selling or refinancing? In that case, negative equity could make things a lot more difficult. For instance, 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 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.”

Refinancing with negative equity is also challenging because lenders usually won’t let you borrow money without any equity in your home. 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.

Economic impact of negative equity

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 home market values to fully recover from their 33 percent drop.

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.

— Ken SissonLos Angeles-based Realtor and associate broker with Coldwell Banker Realty in Studio City, CA

On an individual level, homeowners who put a small down payment or no down payment on their homes may be more likely to go into negative equity – even in a normal housing market. This is because they have less of a stake in their home upfront, so even modest decreases in their property’s value could push them underwater.

What happens when you have negative equity?

If you’re going to stay in your home long-term and can keep making on-time mortgage payments, 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.

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.

How can you reverse negative equity?

Unfortunately, you can’t immediately reverse negative equity, but there are ways to get out of it slowly. The most straightforward option is to wait out the market downturn — 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 increase your home value by investing in home improvements and upgrades. For example, installing new floors, 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.

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 can’t refinance 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 trying to sell or refinance your home.