Referred to as negative equity, being “underwater”, or an “upside-down” mortgage, this home finance challenge affects millions of homeowners. Find out what it is and how to avoid it.
The first time that many people heard about negative equity was in the wake of the 2008 mortgage meltdown. The repercussions of that financial environment, both on homeowners and on the housing market, continued to be felt for many years. More recently, the current economic impact of COVID-19, including high unemployment and financial uncertainty, has threatened to renew concerns about negative equity in some markets.
What do people mean when they talk about negative equity?
Put simply, negative equity occurs when the amount owed on a home mortgage is more than the amount the home is worth. Negative equity is sometimes referred to as being “underwater” or “upside-down” in a mortgage.
Negative equity can occur in a wide variety of ways. Its impact—and any possible solutions—can differ depending on the cause. Here are a few common circumstances under which an unsuspecting homeowner might find themselves underwater:
Economic Recession An economic recession can cause an overall drop in home prices, either because of inflation or higher unemployment rates that, in turn, precipitate increased foreclosure rates. This type of financial shift can cause homes with minimal equity to move into negative equity.
Market Shifts Ups and downs in the local real estate market can affect equity levels. A previously disadvantaged neighborhood might become more desirable,thereby increasing local home prices and adding equity to existing homes in the area. Similarly, a neighborhood that experiences a loss in market appeal can see a commensurate decrease in home values. Thus, a homeowner who bought at “the top of the market” may see his or her equity reduce as local home prices go down.
Insufficient Down Payment Low or no-money-down payment options, though far less common than they once were, serve an important role in making homeownership more accessible for many Americans. However, these types of mortgages can also cause a home to move into negative equity—this may occur if the property loses value before sufficient equity has been added through monthly mortgage repayments or improvements to the home.
Reduction in Property Value Deferred maintenance, or damage to the home that goes unrepaired, can result in a reduction in the overall value of a property. This can also happen if the size or style of houses in an area change, making the property unsuitable for resale except as a teardown. In either case, a severe reduction in property value can cause a home to move into negative equity.
What does negative equity mean for homeowners?
Negative equity has a variety of consequences for homeowners, including:
Lack of liquidity Real estate is a relatively illiquid asset in the best of circumstances, since it generally requires either a home sale or an equity-based loan in order to tap into its value. In the case of negative equity, it becomes almost impossible to sell the home for the amount owed and there is no equity to draw on in order to secure a loan.
Lack of mobility Homeowners stuck in a negative equity situation are unable to sell their homes. Thus, it becomes difficult to move, change jobs, or devote additional money to savings or investments.
Impact on finances Homeowners stuck in a negative equity position may decide that their best option is a short sale or a voluntary foreclosure in order to get out from under the financial burden. This can have devastating long-term consequences on their creditworthiness and their ability to buy a home in the future.
Impact on market In areas where a large number of homeowners find themselves in a negative equity position—for example, in a declining market or during a major economic downturn—the entire neighborhood can begin to experience falling home prices. This can lead to a cascading scenario where many homeowners choose to sell their homes for less than they’re worth or experience foreclosure, especially if job loss in the area is heavy.
How can you prevent or correct negative equity?
If you find yourself upside down in your mortgage–or if you are a hopeful home buyer attempting to avoid finding yourself in that position—here are three things you can do to protect your position in your home mortgage.
Don’t let your home purchase leave you cash-poor. It may be tempting to shop at the top of your home-buying budget or to overextend yourself in order to get exactly what you want. However, it’s best to leave yourself a little wiggle room in your budget, both upfront and monthly, so that you can save for the unexpected and pay for maintenance and upgrades (trust us on this one—they have a habit of springing up when you least expect them).
Save up for the best down payment you can afford. While a low down payment option may be tempting, it may leave you with too little equity in your home should a market downturn occur. If it’s feasible for your budget, try to make a larger down payment, choose a shorter amortization period, or put some of your money into regular payments direct to the principal.
Don’t defer maintenance, and be sure to keep up with home trends. While you don’t necessarily need to have the latest and greatest in home design, keeping up with the styles and materials of homes in your market can help you retain the value in your home while ensuring that you are prepared in case you need to sell.
Simplist offers a variety of tools designed to help you make smarter choices for your home purchase or refinance. With more than 50,000 loan options available, and experts on hand to answer your questions, we’re here to help you feel more confident in every mortgage move you make.