Negative equity occurs when the value of real estate property falls below the outstanding balance on the mortgage used to purchase that property. Negative equity is calculated simply by taking the current market value of the property less the balance on the outstanding mortgage.
Breaking Down Negative Equity
To understand negative equity, we must first understand "positive equity" or rather as it is commonly referred to as home equity.
Home equity is the value of a homeowner’s interest in their home. It is the real property’s current market value less any liens or encumbrances that are attached to that property. This value fluctuates over time as payments are made on the mortgage and market forces play on the current value of that property.
If some or all of a home is purchased by means of a mortgage, the lending institution has an interest in the home until the loan obligation has been met. Home equity is the portion of a home's current value that the owner possesses free and clear.
Home equity can be accumulated by either a down payment made during the initial purchase of the property or with mortgage payments - as a contracted portion of that payment will be assigned to bring down the outstanding principal still owed. Owners can benefit from property value appreciation as it will cause their equity value to increase.
Negative Equity's Economic Implications
When the current market value of a home falls bellows the amount the property owner owes on his/her mortgage, that owner is then classified as having negative equity. For instance, in 2007, a buyer purchased a $400,000 home with a mortgage of $350,000. If the market value of that home in 2008 was $275,000, the owner has negative equity in the home because the mortgage attached to the property is $75,000 greater than what it would sell for in 2008. Negative equity can occur when a homeowner purchases a house using a mortgage before either a collapse of a housing bubble, a Recession, or Depression.
As we saw during the last financial crisis of 2007 -2008, a wide-spread epidemic of negative equity across the housing market can have far-reaching implications for the economy as a whole. Homeowners with negative equity – often referred to as homeowners underwater – found it more difficult to actively pursue work in other areas or states due to the potential losses incurred from the sale of their homes.
The sale of a home with negative equity becomes a debt to the seller as they would be liable to their lending institution for the difference between the attached mortgage and the sale of the home.