Negative equity is when your outstanding mortgage balance is more than the current value of your home. This occurs when your property value has fallen due to a change in the housing market or if you're in the early years of paying off your mortgage and didn't make a large down payment.
Negative equity may not be an issue for many homeowners at present, especially after the past two years of, but it can happen under certain market conditions. When it does it can result in significant financial ramifications for a homeowner.
Here's what you need to know about negativeand how to avoid it.
Why does negative equity occur?
Negative home equity can result from factors that are out of a homeowner's control, such as declines in the housing market or a. Words and phrases such as "underwater" and "being upside-down on your mortgage" are synonymous with the fact that you owe the bank more than what your home is worth.
You can also suffer from negative equity if you didn't make a large down payment and you're a few years into, because most of the amount of your monthly payment goes toward paying down the interest rather than the principal balance of your mortgage.
How does negative equity work?
Let's say you bought your house five years ago for $400,000 and made a $35,000 down payment on a 30-year fixed-rate mortgage at 5%. You've been paying your mortgage monthly over the past five years, paying off $11,500 of your principal balance. That leaves $353,500 owed to the lender. If the value of the home remains at $400,000, you now have $46,500 in "positive" home equity.
However, if real estate values somehow tumbled and your home is appraised at a lower value of, say, $340,000, then you would end up with negative equity because that $353,500 owed on the mortgage is higher than the most recent value of the property.
Equity = Current value - Outstanding debt
Equity = $340,000 - $353,500 = -$13,500 (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 mortgage to your lender.
The downsides of your mortgage being underwater
Your biggest financial investment has lost value: For many homeowners, a home is the most expensive purchase they'll make in their lives, and it's been a reliable way to build wealth over time. But when the home's value drops below the value of the mortgage, the net worth drops too. Your largest asset now has a negative value.
No access to home equity loans: Negative equity also means that you don't have any equity to borrow against your home. Without equity to borrow, lenders won't approve you for a, or any type of financing that relies on your home as collateral.
Moving to another home may not be an option: The average homeowner needs to sell their home in order to move to another one. But if you sell your home when its value is lower than what you paid for, you'll owe the bank money instead of benefiting from the sale -- and a lender won't close on your home sale until you pay them back in full.
How to prevent being upside-down on your mortgage?
Although you can't predict which way the market will go, you canas to how you'll pay for your home, as well as the location and timing of when to buy. Consider waiting out the top of the housing market 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 as large of a down payment as possible: Making a large down payment is the fastest way to building equity in your home. 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.
Don't buy a home when prices are skyrocketing: Although many people scrambled to buy houses during the pandemic, they bought at the top of the market and paid a premium for those properties. As the housing market continues on a correction and home prices slowly continue to decline, those homes are losing some of their value. Consider buying a house that's expected to increase in value, not one that's already at its peak value.
Buy in an established location: Some regional housing markets are more at risk than others for losing their value. For example, cities that became pandemic hot spots such as Boise, Idaho, had some of the biggest gains in home sales over the past two years, but are now losing their value faster than more established markets such as New York and Boston, where people still desire to live as regular work and school schedules fall back into place.
Buy a house you can afford: Don't let your eyes become bigger than your wallet. If your mortgage payments are too expensive and you fall behind, you could also end up with negative equity, as well as put yourself at risk of foreclosure.
The bottom line
The simplest way to avoid negativeis to make a large down payment when you purchase your home. If that's not possible, be strategic about when and where you buy a house. Avoid buying a house at the top of the market when there's a possibility that home values could fall in the near future. Also, consider buying in a location that has proved consistently desirable to homeowners.