Negative equity

Negative equity occurs when the value of an asset used to secure a loan is less than the outstanding balance on the loan.^[1] In the United States, assets (particularly real estate, whose loans are mortgages) with negative equity are often referred to as being "underwater", and loans and borrowers with negative equity are said to be "upside down".

People (and companies) may also have negative equity, as reflected on their balance sheets.

Negative Equity in an Asset

While typically a result of fluctuating asset prices, negative equity can occur when the value of the asset stays fixed and the loan balance increases because loan payments are less than the interest, a situation known as negative amortization. The typical assets securing such loans are real property – commercial, office and residential. When the loan is nonrecourse, the lender can only look to the security, that is, the real property when the borrower fails to repay the loan.

In owner-occupied housing market, a fall in the market value of a mortgaged house or condo is the usual cause of negative equity. Negative equity in the owner-occupied market sometimes occurs when the owner obtains second-mortgage home-equity loans, causing the combined loans to exceed the home value. If the borrower defaults, repossession and sale of the property by the lender will not raise enough cash to repay the amount outstanding, and the borrower will both have lost the property and still be in debt. Some states like California require lenders to choose between going after the borrower or taking repossession, but not both.

The term negative equity was widely used in the United Kingdom during the economic recession between 1991 and 1996, and in Hong Kong between 1998 and 2003. These recessions led to increased unemployment and a decline in property prices, which in turn led to an increase in repossessions by banks and building societies of properties worth less than the outstanding debt.

It is also common for negative equity to occur when the value of a property drops shortly after its purchase. This occurs regularly in automobile loans, where the market value of a car might drop 20-30% as soon as the car is driven off the lot.

Since 2007, those most exposed to negative equity are borrowers who obtained high value mortgages that were commonplace before the credit crunch, as they are most at risk from declines in property price.^[2]

Negative Equity on a Balance Sheet

To say a person has negative equity is the same as to say he has "negative net worth" (where his liabilities exceed assets). One might come to have negative equity as a result of taking out a substantial, unsecured loan. For example, one might use a student loan to pursue higher education. Although education may increase the likelihood of higher future earnings, that potential is not a financial asset.

In the United States, student loans are non-dischargeable in bankruptcy, and typically lenders provide student loans without requiring security. This stands in contrast to lenders requiring borrowers to have an equity stake in a comparably-sized real estate loan, as described above, secured by both a down payment and a mortgage. An explanation for the willingness of creditors to provide unsecured student loans is that, in a practical sense, American student loans are secured by the borrower's future earnings. This is so since creditors may legally garnish wages when a borrower defaults.

See also

• Mortgage loans
• Negative amortization
• Loss mitigation
• Strategic default
• Equity (finance)

References

1. ^ America's foreclosure plan: Can’t pay or won’t pay?, Paragraph 5, The Economist (February 19, 2009).
2. ^ Ruth Jackson, The return of negative equity, MoneyWeek (April 18, 2008).

• Irwin, Robert. Home Seller's Checklist: Everything You Need to Know to Get the Highest Price for Your House. McGraw-Hill Professional. p. 180. 
• Nerad, Jack (1996). The Complete Idiot's Guide to Buying or Leasing a Car. p. 129. 
• http://www.edmunds.com/advice/strategies/articles/104952/article.html
• http://money.cnn.com/2005/08/04/real_estate/buying_selling/home_equity_falling/index.htm