When a home falls in value to the point where it is worth less than the amount its owner owes on his mortgage, it falls into negative equity. This can happen in any economic downturn, regardless of severity or duration. But given both the unprecedented severity and duration of last decade’s downturn, negative equity grew like it was on steroids.
What is negative equity? When a homeowner has negative equity, that’s also known as being underwater. It means she owes more money on her mortgage than she could make on the sale of her home. As we learned in the last recession, the implications of negative equity for individuals and for the economy can be enormous.
A primary reason people buy homes rather than rent is to use that home as an investment as it grows in value, and that’s all about the equity they build. Equity grows as a home’s value increases. If you buy a home for $100,000 with $20,000 down and take out an $80,000 mortgage to cover the rest, you have $20,000 in equity right away. If your home gains $25,000 in value over the next five years, then you have your $20,000 down payment plus the $25,000 market gain, for a total of $45,000 in equity – plus however much you have paid down on the principal you owed on the original $80,000 mortgage.
Another way to look at it: Equity is roughly the amount you could sell your house for, minus what you owe on it. When people accrue enough equity in their homes, they can use that equity for other purposes, such as taking out home equity loans – short-term loans using their equity as collateral.
Equity typically grows with the real estate market over time and is a great wealth builder for millions of families. But when home values drop, as they did last decade, so does the equity people have in their homes.
When a home falls in value to the point where it is worth less than the amount its owner owes on his mortgage (if, for example, that $100,000 home falls in value to $75,000 – less than the $80,000 mortgage on it), it falls into negative equity. This can happen in any economic downturn, regardless of severity or duration. But given both the unprecedented severity and duration of last decade’s downturn, negative equity grew like it was on steroids.
At the peak of the negative equity crisis in early 2012, nearly a third of all homeowners with a mortgage – 16 million people – had negative equity in their homes. At the end of 2017, roughly 5 million homeowners still were underwater, more than half of them deeply so, with mortgage balances totaling 120 percent or more what their homes were worth.
Negative equity can cast a shadow over the economy, effectively prolonging an economic downturn. Just as skyrocketing home values can drive confidence and spending, negative equity can keep people home, literally. Many people who might have found jobs in other markets were tied to their homes and unable to sell because the money they would make from selling would not be enough to pay off their mortgages. Negative equity can have a number of other chilling impacts on local housing markets, disproportionately impacting minority communities and owners of lower-valued homes, exacerbating inventory shortages and increasing the likelihood of foreclosure for underwater homeowners.
Most of the millions of people still upside down on their mortgages are waiting – and weighing what to do.
In additional to simply paying off your loan over time, the surest way to get out of negative equity is to wait for a home’s value to appreciate enough to bring it into positive equity. And in markets where home values continue to rise and for homeowners who are in no rush to move, waiting for negative equity to turn positive may be the solution. But it could be a long wait for the more than 15 percent of underwater homeowners who owe at least twice what their homes are worth.
There are other ways to eliminate negative equity, short of relying on loan repayment and/or simple home value appreciation. A homeowner can attempt to negotiate a short sale with their lender, hoping their lender will agree to take less than what is fully owed on a mortgage. In the event a lender refuses, a homeowner can also bring their own money to the closing table in order to make up the difference between the price offered on a home and the outstanding balance on the mortgage. Both solutions are complicated, time-consuming, risky and expensive – and so very uncertain.
The other sure-fire way to reduce negative equity is through foreclosure. When a home is foreclosed upon, all associated mortgage debt is wiped clean, and a homeowner can start anew (although, typically, won’t be able to get a new mortgage for at least seven years post-foreclosure). But in another indicator of just how much negative equity can distort the market, a falling foreclosure rate in this case is actually a “bad” thing. At the end of Q1 2012, the height of negative equity, roughly 7.2 out of every 10,000 homes nationwide was sold as a foreclosure. By December 2016, that rate had fallen to about 1.2 homes for every 10,000 nationwide. Fewer foreclosures means less negative equity wiped clean in that way.
Some homeowners hold mortgages with balloon payments and other terms that will greatly increase their payments if they do not refinance. Because mortgage lenders want collateral to match the amount they’re lending, it can be tricky to refinance a home in negative equity. The recession sparked a number of special refinancing programs to help.
We should be prepared for negative equity to remain a part of the U.S. housing market for a long time to come. It is likely to continue to fall as home values increase, freeing those already relatively close to positive equity. But even as home values close in on peak levels reached during the housing boom, those deeply underwater homeowners still face a long wait before returning to a positive balance on their home loans. We’re likely in store for a kind of new environment in housing, one in which the longer-term level of negative equity is substantially higher than the roughly 3ish percent we’d expect to see in a historically “normal” market. Negative equity cut the housing market very deeply, and its scars are likely to be long-lasting.
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