Negative Equity: What You Need To Know
A home can be a good investment. Ideally, homeowners will earn money from the home appreciating in value. The hope is they’ll sell it for more money than they paid for it, or at least more money than they still owe on it. The difference between what you owe on the home and what it’s now worth is your home equity.
To determine your home equity, you simply subtract what you owe on your home loan from what your home is worth. For example, if your home is worth/sells for $300,000 and you still owe $200,000 on your mortgage, you have $100,000 in equity.
If your home equity is more than zero, you have positive equity. You usually build your equity by paying down your loan balance or by increasing your home value. However, there’s a chance that your equity could fall, resulting in negative equity.
What Is Negative Equity?
When the value of a property falls below the outstanding balance on the mortgage, it’s called negative equity. That means you owe more on your home than it’s worth. Although negative equity isn’t always preventable, understanding the reasons why it occurs can help you find the best solution to move the needle toward positive equity.
Underwater Mortgages, Upside-Down Loans And Negative Equity
Lenders, agents and other real estate professionals use a number of different terms when they refer to negative equity. The expression you’ll see most often is “underwater mortgage,” which is an informal way to describe a homeowner who owes more on their home than its current value.
Some people also use “upside-down loan” and “negative equity” interchangeably. Once again, the two terms refer to the exact same situation. If your lender tells you that your mortgage is underwater or upside-down, it means that you have negative equity.
What Is The Loan-To-Value Ratio?
When someone is purchasing a home, the loan-to-value (LTV) ratio is typically used to assess lending risk and to help a lender decide whether to extend credit. It also determines a borrower’s interest rate, the type of loan they can get and whether they may need to pay for private mortgage insurance.
LTV is a percentage that represents the relationship between the amount owed on the loan and the appraised value of the home. It’s calculated by dividing the amount on the loan by the appraised value of the home.
For example, let’s say you want to purchase a home that’s worth $300,000 and you take out a mortgage for $250,000 to purchase it. To get your LTV, you would divide $250,000 by $300,000, which equals about 0.83 or 83%.
The more equity you have in the home, the lower your LTV will be. The higher your LTV, the less equity you have and the bigger risk you are to lenders. And when your LTV is over 100%, you have negative equity in the home and are upside down on your mortgage.
What Causes Negative Equity?
Negative equity can be a result of several different factors, some that are in your control and some that may be out of it. Here are a few causes of negative equity and tips for preventing or lessening their risk.
Market decline: This is one of the most common reasons homeowners experience negative equity. They may purchase a home or borrow against their home when the market is at its peak – and then the market drops dramatically, sending home values plummeting.
Yes, the market can drop – and has. Chances are it will do so again. But don’t let that prevent you from purchasing a home. While some may have a few lingering memories of the past, there are better regulations, safer loan products, stricter requirements and minimum down payments for most programs. The state of the market and where it goes isn’t fully in your control, but you can take some steps to be a more informed borrower.
Educate yourself on the market and stay updated on where it is and where it’s predicted to go. Get your information from multiple, trusted sources, including real estate professionals. If the market does dip, don’t freak out. There are some actions you can take that we mention further in this article.
High-interest loans: Borrowers who are determined to be high-risk will be charged a higher interest rate than those who are considered low-risk. With high-interest loans, borrowers end up having most of their monthly payments go toward paying interest instead of paying down the loan.
Factors that make you a high-risk borrower include a low credit score, a high LTV, a credit report littered with red flags or an unstable job status. If any of these factors resonate with your situation, consider taking time to learn more about your finances, improve your credit score, save for a down payment or pay down debt.
This will help you qualify for a loan with a lower interest rate and could save you money in other ways, too.
Poor home condition: The value of a home relies, in part, on its condition. If you allow your home to fall into disrepair, its value will decline. Make sure you maintain your home, make repairs as soon as there is an issue and even make improvements to the home when you are able.
Small down payment: The more money you put down on a home, the more equity you’ll have from the get-go, which can protect you from market dips. If you take out a loan with little or no money down and the market drops soon after you purchase, you’ll almost immediately have negative equity because you didn’t have much, if any, in it before. Take the time to save up for a larger down payment or consider more affordable properties.
Low appraisal: A lender cannot lend more than the appraised value of a home. So, if the appraisal comes in lower than the agreed-upon price, the seller may ask you to pay the difference out of pocket. If you do that, you’re already going into the purchase with negative equity because you’re paying more than the home is worth. Instead, you should work with the seller to see if they’ll reduce the price to the appraised value. If not, you may want to consider walking away from the deal.
Can You Sell A Home With Negative Equity?
While being upside down on your mortgage won’t prevent you from selling your home, you will need to pay the difference between the sale price and the balance on your loan. So, if your home sells for $200,000 and you owe $225,000 on your loan, you’ll need to pay the lender $25,000.
If you don’t have $25,000 in cash on hand, you may want to think about one of these alternative solutions instead.
Negative equity doesn’t have to mean a financial apocalypse. While things may not have gone the way you planned when you first purchased the home, you can still get back on track or at least lessen the burden.
Wait it out: If you have negative equity from a drop in the market, you could continue to make monthly payments as normal and wait it out. Typically, the market will go back up eventually; you’ll just need to decide if you’re willing to wait and for how long.
Make extra payments: If you can, make extra payments on the loan along with your normal monthly payments. For most loans, you’ll be able to choose to apply that extra payment to the principal balance only. This will lower your balance and increase your equity faster. One simple way to make one full extra payment on your loan is by making biweekly payments on your mortgage instead of one monthly payment. Simply pay half your monthly payment every other week and at the end of the year, you’ll have made 13 payments instead of 12.
Rent your home: If you can’t sell your home due to negative equity, consider renting it out until the market improves or you have positive equity. You could rent out a room in the home or move into a smaller, more affordable space and rent out the entire home.
Raise the value of your home: Raising the value of your home is one way to increase the equity you have in it. A few ways to increase the value in your home include:
- Upgrading your kitchen or bathroom
- Upgrading old appliances
- Improving the curb appeal
- Repairing roof, foundation or plumbing issues
- Replacing your heating and cooling units
- Finishing your basement
- Adding a patio
Whatever you do to raise the value of your home, make sure your changes are affordable and don’t put you into more debt.
Refinancing With Negative Equity
Another option is to refinance your mortgage to lower your interest rate or get rid of your PMI, which can lower your monthly payments. A refinance could also shorten your loan term, but that will also increase your monthly payment. With negative equity, the process to refinance into a new loan will be more complicated. Most of the time, a lender cannot loan you more than the home is worth, so it may fall on you to pay the difference out of pocket.
There are a few assistance programs available for people who are underwater on their mortgage, including Fannie Mae’s High Loan-To-Value Refinance Program (HIRO) or Freddie Mac’s Relief Refinance Program (FMERR). These programs have specific requirements to qualify.
The Bottom Line
Negative equity happens when you owe more on your mortgage than what your home is worth. There are a few factors that can cause this, including falling home values and high-interest loans. It can also be caused by certain actions a buyer may make when purchasing the home, like making a small down payment or paying the difference after an appraisal comes in low.
Negative equity can make it difficult to sell a home or even refinance your loan. If you find yourself upside down on your mortgage, try to find ways to pay down your loan balance or increase the value of your home to lessen the blow. If you have mortgage-related questions, you can speak with a Home Loan Expert today.