Conventional wisdom used to dictate that real estate always appreciates in value. Although that's often true in the long term, fluctuating values sometimes leave homeowners owing more on their mortgages than their homes are worth. This puts a homeowner in a negative-equity position that's commonly referred to as being "underwater" or "upside down."
Market value is the amount of money a well-informed buyer will pay for a home that has been on the market for a reasonable time. Appraisers evaluate a particular home's market value by comparing the home to similar homes that have sold recently. In other words, the appraiser determines how much a buyer will pay by looking at prices buyers did pay for similar homes. The appraiser tweaks the final number by making adjustments for ways in which the subject home compares favorably or unfavorably to the similar homes.
Equity is the portion of your home's market value that you own outright. For example, if you purchased your home for $200,000 using an $180,000 loan, and the home's market value at that time was $200,000, you had $20,000 in equity right from the start. If your home's market value was $225,000, you had $45,000 in equity even though you only paid $200,000 for the home. The more equity you have, the better able you are to ride out fluctuating values.
How Negative Equity Happens
Over time, real estate market values can trend in three different ways: they can increase, decrease or remain stable. Stable values allow you to increase your equity a little bit each time you make a mortgage payment. When the value remains unchanged from one month to the next, each dollar that goes toward your principal corresponds with a dollar increase in equity. Property values that trend upward give you "free" equity, so to speak. In addition to the dollar-for-dollar increase from your principal payments, you also get a dollar of equity for every dollar your property value increases. Conversely, you lose a dollar of equity for each dollar your property value drops. When your principal payments fail to boost your equity more than a declining market reduces it, negative equity eventually results.
Negative equity's primary consequence is that it makes it difficult for you to sell your home. Your mortgage contract probably requires that you repay your loan in full when you sell your home. If the home is worth less than you owe, you can't repay the loan from the proceeds of the sale -- you have to bring cash to the closing table to repay the portion of the loan the sale price doesn't cover. Most buyers lack the means to pay this amount out of pocket. Negative equity also keeps you from borrowing against your home. Home equity loans generally allow you to borrow only a percentage of your equity. If you have no equity, there's nothing against which to borrow. In the most extreme cases, where values drop through the floor and have little chance of recovering, you could find yourself deeper in the hole as each month passes, even as you continue paying your loan.
Increase Your Equity
Underwater homeowners have several options. The first is to wait it out by sitting tight until values rise again. If you have the cash, you might consider making a lump-sum principal payment or paying extra toward your principal when you make your mortgage payments. Alternatively, you can sell your home by tapping your savings or borrowing money from family to pay off the loan. In this case, however, it's unlikely that you'll be able to afford to buy a home to replace the one you sell.
Mortgage modification provides relief to underwater homeowners by reducing their mortgage interest rates, reducing the amount of principal they owe or extending the time borrowers have to repay their loans. Several government-sponsored Making Home Affordable programs modify mortgages or allow homeowners to refinance, even with negative equity. Modification options exist for most loan types, including FHA, Freddie Mac, Fannie Mae and VA loans as well as conventional loans from private lenders.
Short Sale and Deed in Lieu
A short sale or deed in lieu of foreclosure is a final option for homeowners who don't qualify for modification and are unable to continue making payments. A short sale is one in which your lender allows you to sell your home for less than you owe on the mortgage. The lender accepts the sale price as repayment and essentially forgives the rest of your loan. With a deed in lieu of foreclosure, you give your home back to the lender voluntarily rather than wait for the lender to foreclose. Short sale and deed in lieu actions usually result in steep declines in your credit score, and you might have to pay income tax on the amount of the loan your lender forgives. A housing counselor or attorney can help you decide if either of these options is right for you.
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