What Is Negative Home Equity?

If you’ve been reading the headlines about the housing market, it’s easy to assume that every homeowner is sitting on a huge pile of equity. While the majority of homeowners across the country have reaped the benefits of soaring housing valuations, it’s not the case for everyone. 

A small percentage of homeowners have negative home equity. Negative equity occurs when your outstanding mortgage balance is more than the current value of your home. Here’s what you need to know about negative home equity and how to avoid it.

What is negative home equity?

Negative home equity -- commonly referred to as an upside-down mortgage, or being underwater on your mortgage -- is when the amount of your home loan exceeds the amount that your home is worth on the market. This typically occurs when property values have fallen due to a change in the housing market. It can also be an issue if you made a small down payment and are just starting to make home loan payments to your mortgage lender.

According to the latest numbers from CoreLogic, there are approximately 1.1 million homes with negative equity in the US. That represents just 2% of all properties with a mortgage. So, while it’s not a huge issue in today’s housing market, it’s proof that even after the pandemic-fueled run-up in housing prices, some homeowners are still upside down in their mortgages. 

How does home equity work?

Home equity is the difference between the remaining loan balance on your current mortgage and the fair market value of your home. For example, if your home is worth $425,000, and you owe $300,000 to your lender, you have $125,000 of equity -- let’s call it positive equity. You build home equity every time you make mortgage payments and cover a portion of the principal balance, and you also naturally accumulate equity if the property value increases.

However, if the property value decreases, your equity also declines. For example, if you owe $300,000 to your lender and the value of your property is appraised at $285,000, you have negative equity. Even if your home value decreases and you have negative equity, you’re still responsible for paying back the full amount of your home loan to your lender. 

Why does negative equity occur?

Negative home equity often results from factors out of a homeowner’s control, such as a dip in real estate values. Consider the great recession of 2008. When the housing bubble burst, home values tanked and 24% of homeowners had negative equity at the end of 2009. Home values continued to tumble, and by the end of 2012, more than 31% of homeowners had underwater mortgages.

While there have been concerns of another economic downturn as the Fed has aggressively hiked interest rates, the reality is that a recession -- or worse, a depression -- with loads of mortgage equity withdrawal is highly unlikely. The housing market is in solid shape in most parts of the country.

Negative equity can also occur from failing to maintain a property. For example, if a homeowner lets the roof fall into disrepair and leaks create major mold problems inside the home, the value of the property suffers.

The downside of your mortgage being underwater

• Your biggest financial investment has lost value: When your home’s value drops below the value of your existing mortgage, your net worth drops too. Your largest asset now has a negative value. 

• You have less borrowing power: Without positive equity, lenders won’t approve you for a home equity loan, home equity line of credit or any type of financing that relies on your home as collateral. Many homeowners rely on home equity loans to consolidate high-interest debt or pay for renovations that increase a home’s value. 

• You probably can’t afford to move: The average homeowner needs to sell their home in order to move to another one. And if you have negative equity, you’re going to have to come up with the difference to pay back your lender. 

Tips for avoiding negative equity

• Make a big down payment: Making a larger down payment means you have a larger chunk of home equity to access from the very beginning of paying off your mortgage. 

• Avoid overpaying: Consider waiting to buy if you find yourself in bidding wars or having to make offers on the spot. Remember, the housing market is cyclical, so it’s possible you’re only a few years away from more affordable housing options.

• Make regular investments in your property: A kitchen remodel, a bathroom update, a finished basement -- these are all examples of projects that can increase your home’s current value. While you’ll need to spend (borrow) money to make home improvements, they make your property more appealing when it’s time to sell your home.

Can you reverse negative equity?

If you have negative equity in your home, you’re not alone. In fact, nearly 5% of all mortgaged homes in Iowa and just over 6% of homes in Louisiana have negative equity, representing the two largest shares of underwater mortgages in the US.

While you can’t reverse negative equity, there are a few important pieces of advice to follow to avoid falling into a bigger hole:

• Make bigger mortgage payments: If you can afford to pay more than the minimum monthly payment on your home loan, direct every extra dollar toward your loan principal as long as there’s no potential for prepayment penalties. For example, let’s say you’re $10,000 underwater. If you make extra payments of $250 each month for the next year, you’ll chip away at $3,000 of that negative equity. 

• Wait out the market: As you make those extra monthly payments, keep your fingers crossed that your local housing market conditions improve. Home prices usually go up in the long run, so time should be on your side.

• Keep your place in good shape: Don’t let negative home equity discourage you from thinking you shouldn’t bother with your regular homeowner duties. Mow the lawn, service the HVAC system, clean the gutters -- do everything you need to keep it pristine. When it’s time to sell (and try to make that time a long way in the future), those efforts will pay off.