Definition
Negative equity occurs when the value of an asset, often a property, falls below the outstanding balance on the loan used to purchase that asset. Essentially, it means that the borrower owes more on the loan than the asset is currently worth. This situation typically arises when property values decrease or if the loan’s principal balance isn’t significantly reduced over time.
Key Takeaways
- Negative equity occurs when the value of an asset, especially a real estate property, is less than the outstanding balance on the loan used to purchase that asset. Essentially, it implies that the owner owes more on the loan than the present market value of the asset.
- Negative equity is generally caused by a decline in value of an asset after its purchase or an increase in debt, thereby causing imbalances. This situation often occurs during a housing market downturn when home prices fall sharply.
- Having negative equity can be problematic as it limits one’s financial flexibility. For instance, if you’re in negative equity and wanted to sell your asset, you would not make enough from the sale to repay your lender and would have to make up the difference from your own funds.
Importance
Negative equity is an important finance term as it indicates a financial situation where the value of an asset, often a home, becomes less than the loan amount owed on it.
It usually occurs when property values decrease or if the property owner acquires too much debt.
This situation is significant because it can limit a person’s mobility – as they might not be able to sell their property without incurring a loss – and it can lead to foreclosure if they are unable to keep up with their repayments.
Therefore, understanding negative equity can help individuals avoid harmful financial decisions or seek help if they find themselves in this predicament.
Explanation
Negative equity, referred to as “being underwater”, is a financial situation that arises when the value of an asset falls below the outstanding balance of the loan used to purchase that asset. This situation is most common in home mortgages, particularly when the housing market declines. It may also occur with vehicles and other tangible properties.
Negative equity indicates that the asset owner owes more on the loan than the asset’s worth in the market, shrinking their net asset value. The primary purpose of identifying negative equity is to measure financial health and potential risk for both individuals and financial institutions. For individuals, having a property in negative equity can lead to serious financial problems, particularly if they need to sell the property or if they struggle to keep up with payments.
For financial institutions such as banks and mortgage lenders, high levels of negative equity among their borrowers can indicate increased risk of defaults and foreclosures. Borrowers with negative equity are more likely to default on their loans because they have less to lose by doing so. In such cases, the negative equity serves as an indicator necessitating strategic reassessment or intervention, to protect both the borrower and the lender.
Examples of Negative Equity
Underwater Mortgage: This is one of the most common examples of negative equity. When the housing market crashes, the value of homes can decrease significantly. If a homeowner originally bought their home for $300,000, for example, but now it is only worth $250,000 and they still owe $275,000 on their mortgage. In this case, they are $25,000 in negative equity because they owe more on their home than it is currently worth.
Automobile Depreciation: When you purchase a new car, its value begins to quickly depreciate. If you finance the car with a low down payment, you can easily find yourself in a negative equity situation where you owe more on the car loan than the car is actually worth, especially if the car is damaged or totaled.
Credit Card Debt: If someone has been excessively using their credit card without being able to fully pay off the debt, credit card interest can lead to negative equity. The individual may end up owing more money on the credit card bill than they have assets that can be used to repay the debt. This situation can be worsened if penalties and fees are added to the original debt.
FAQs on Negative Equity
What is Negative Equity?
Negative equity occurs when the value of an asset, most commonly real property, is less than the outstanding debt on the loan used to purchase that asset.
What causes Negative Equity?
Main factors that can lead to negative equity include a decline in property value, an increase in mortgage debt, or both.
Does Negative Equity impact on mortgage payments?
No, negative equity does not change the amount of monthly payments you make to the bank, but it can affect your ability to move or sell the house.
How can you mitigate Negative Equity?
The most common strategies to mitigate negative equity include making additional payments, restructuring the loan, or staying put until property values increase.
Can you sell a house with Negative Equity?
Yes, but the processes – like short sales or strategic default – can be complex and may have a negative impact on credit scores.
Related Entrepreneurship Terms
- Underwater Mortgage
- Depreciation
- Property Value Decline
- High Loan-to-Value Ratio
- Debt Exceeds Market Value
Sources for More Information
- Investopedia – This website provides useful information about finance and investment terms, including ‘Negative Equity’.
- Bankrate – Bankrate is a consumer financial services company that can provide information about ‘Negative Equity’ in terms of home financing, specifically mortgages.
- Consumer Financial Protection Bureau – This U.S. government agency provides information about financial terms and protections for consumers’ rights, including those facing ‘Negative Equity’.
- NerdWallet – NerdWallet is a personal finance company that offers information and tools about personal finance topics, including ‘Negative Equity’.
