What Is Negative Equity?
Negative equity occurs when the value of an asset falls below the outstanding balance of the loan used to purchase that asset. This financial condition is most commonly associated with significant purchases, particularly in the realm of personal finance such as real estate (e.g., a mortgage) and vehicles (e.g., an auto loan). When a borrower holds negative equity, their ownership stake in the asset effectively becomes less than zero, meaning that if they were to sell the asset, the proceeds would not be enough to cover the remaining debt. This situation is often referred to as being "underwater" or "upside down" on a loan.
History and Origin
The concept of negative equity gained widespread attention during major economic downturns when asset values experienced significant declines. In the United States, the subprime mortgage crisis of 2008-2009 brought negative equity into sharp focus. During this period, millions of borrowers found their homes were worth less than the amount they owed on their mortgages, largely due to a severe contraction in housing prices36. This created adverse economic incentives for borrowers, similar to those seen with upside-down auto loans, where the debt exceeds the collateral's value35. Negative equity was also a prevalent issue in the United Kingdom during the economic recession of the early 1990s, leaving many homeowners trapped in properties they could no longer afford33, 34.
Key Takeaways
- Negative equity arises when the market value of an asset is less than the loan balance secured by that asset.
- It is most commonly observed in real estate and automobile financing.
- Factors contributing to negative equity include declining market values, rapid depreciation, small down payments, or financing additional costs into the loan.
- Having negative equity can limit a borrower's financial flexibility, making it challenging to sell the asset or refinancing the loan.
- While a challenging situation, it is often temporary, and strategies exist to address it.
Formula and Calculation
The calculation of negative equity is straightforward. It involves comparing the current market value of an asset to the outstanding balance of the debt secured by that asset.
The formula for negative equity is:
If the result of this calculation is a negative number, then negative equity exists.
For example, if a home's current market value is $250,000 and the outstanding mortgage balance is $280,000, the negative equity would be:
In this case, the homeowner has $30,000 in negative equity.
Interpreting Negative Equity
Interpreting negative equity primarily involves understanding its implications for a borrower's financial flexibility and net worth. A negative value indicates that a significant portion of an individual's or company's liability exceeds their corresponding asset value. This situation can severely restrict a borrower's options, such as selling the asset without incurring a financial loss or obtaining further financing.
For instance, if a homeowner with negative equity needs to relocate, they might face the difficult choice of bringing a substantial amount of cash to the closing table to cover the difference between the sale price and the loan balance, or potentially pursuing a short sale with their lender's approval. In auto financing, if a vehicle with negative equity is totaled in an accident, the insurance payout typically covers only the vehicle's market value, leaving the owner responsible for the remaining loan balance31, 32.
Hypothetical Example
Consider a new car purchase. Sarah buys a car for $35,000 and takes out a loan for the full amount, with a minimal down payment and including taxes and fees rolled into the loan. The total loan amount is $38,000. New cars typically depreciate rapidly as soon as they are driven off the lot. Let's say within the first year, the car's market value depreciates by 25%, making it worth $26,250.
Meanwhile, after one year of payments, Sarah has reduced her loan balance to $36,000.
Applying the negative equity formula:
Current Market Value of Asset = $26,250
Outstanding Loan Balance = $36,000
Sarah now has $9,750 in negative equity. If she needed to sell the car at this point, she would owe an additional $9,750 beyond the sale price to pay off her loan. This scenario is common in the early stages of auto loans due to rapid vehicle depreciation30.
Practical Applications
Negative equity primarily manifests in secured lending, impacting both individuals and broader economic markets.
In real estate, homeowners can find themselves with negative equity if property values decline significantly, or if they took out a large initial loan or subsequently borrowed against their equity with a second mortgage. This can make selling a home problematic, as the sale price may not cover the outstanding mortgage balance29. The ability to obtain new financing, such as a home equity loan or line of credit, is also severely hampered28. The Federal Reserve Bank of Boston has conducted research on the implications of negative equity, noting its role as a necessary, though not sufficient, condition for foreclosure27.
In auto lending, negative equity is a common occurrence due to the rapid depreciation of vehicles, especially new ones25, 26. Data from the Consumer Financial Protection Bureau (CFPB) indicates that a notable percentage of vehicle loans involve negative equity, particularly when consumers trade in an older vehicle with an outstanding balance23, 24. This means that a portion of the old loan's negative equity is rolled into the new car loan, leading to a larger new loan and potentially higher monthly payments21, 22.
Negative equity also has broader implications for economic stability. Widespread negative equity in a market can lead to reduced consumer spending, limit labor mobility (as homeowners are "trapped" in their homes), and pose risks to financial institutions holding these underwater loans20.
Limitations and Criticisms
While negative equity clearly presents challenges, it's important to understand its nuances and limitations. One key point is that simply having negative equity does not automatically lead to severe consequences like foreclosure for individuals, particularly if they can continue to make their loan payments19. However, it can significantly reduce financial flexibility and create psychological stress18.
A major criticism arises when borrowers face unforeseen financial hardship. If a homeowner loses their job while in negative equity, their options become extremely limited. In some jurisdictions, lenders may still pursue the borrower for the outstanding balance after repossession if the sale of the asset does not cover the full debt, which can leave individuals in further debt even after losing their property17. The risk is particularly acute in situations where borrowers have a low loan-to-value (LTV) ratio at the time of purchase and then experience a significant market downturn16.
Furthermore, for companies, a negative balance in the balance sheet's shareholder equity section can signal financial distress and potential bankruptcy, though in some cases it might be a result of aggressive share buybacks or significant early-stage investments rather than operational losses14, 15. However, this typically signals that the company's liabilities exceed its assets13.
Negative Equity vs. Underwater Mortgage
The terms "negative equity" and "underwater mortgage" are often used interchangeably, particularly in the context of real estate. Both refer to a situation where the amount owed on a loan is greater than the current market value of the asset securing that loan.
The main distinction, if any, lies in their scope:
- Negative Equity is a broader financial term applicable to any asset financed with a loan, including homes, cars, and even extending to a company's overall equity position. It describes the state where an asset's value is less than its associated liability.
- Underwater Mortgage specifically refers to a negative equity situation involving real estate. It implies that a homeowner owes more on their home loan than the house is currently worth12.
Therefore, all underwater mortgages represent negative equity, but not all instances of negative equity involve a mortgage; for example, an upside-down auto loan also represents negative equity10, 11. The phrases "upside down" or "underwater" are popular colloquialisms for negative equity, especially in consumer lending9.
FAQs
What causes negative equity?
Negative equity primarily occurs when the market value of an asset declines after purchase, or when the loan amount taken out is very high relative to the asset's initial value (e.g., a low down payment). Factors like economic downturns, rapid depreciation (for vehicles), and accumulating additional debt (like rolling taxes and fees into a loan) can contribute to this6, 7, 8.
Is negative equity always a problem?
Not necessarily. If you intend to keep the asset (e.g., your home or car) for a long period and can continue making your loan payments, negative equity may not be an immediate problem. Asset values can recover over time, and consistent payments will reduce your outstanding loan balance, eventually leading to positive equity4, 5. However, it becomes a significant issue if you need to sell or refinancing the asset3.
Can negative equity affect my credit score?
Negative equity itself does not directly impact your credit score. However, the circumstances that often lead to or accompany negative equity, such as missing loan payments or defaulting on the loan, can severely harm your credit1, 2. If you are forced to sell at a loss or pursue a short sale, these actions can also negatively affect your credit.