Can You Have Negative Equity & What to Do About It

Negative equity is a financial condition where the value of an asset becomes less than the outstanding balance of the loan used to acquire it. This situation means the owner owes more on the asset than it is currently worth in the market. While commonly associated with real estate, negative equity can affect various financed assets, including vehicles.

Defining Negative Equity

Negative equity occurs when the market value of an asset falls below the amount of debt secured by that asset. The calculation is straightforward: if the loan balance is greater than the asset’s current market valuation, negative equity exists. For example, if a home is appraised at $250,000 but the mortgage balance is $270,000, there is $20,000 in negative equity.

How Negative Equity Develops

Several factors contribute to the development of negative equity, often stemming from market conditions or the nature of the financed asset. For real estate, a decline in property values can lead to this situation. Market downturns, localized economic shifts, or purchasing a home at the peak of an inflated market can cause the property’s value to drop below the outstanding mortgage.

Vehicles frequently experience rapid depreciation from the moment they are driven off the dealership lot. A new car can lose an average of 16% to 20% of its value within the first year alone. This quick decline, combined with long loan terms, can quickly place a vehicle into negative equity. General factors such as making a small down payment, which results in a high loan-to-value (LTV) ratio at the outset, also contribute.

High interest rates can slow the reduction of the principal balance on a loan, meaning equity builds more slowly than the asset depreciates. If the loan balance reduces at a slower pace than the asset’s market value declines, negative equity can arise.

The State of Negative Equity

Being in a state of negative equity presents immediate financial realities for the asset owner. If the asset needs to be sold, the owner would typically need to pay the difference out-of-pocket to cover the outstanding loan balance. For instance, selling a home with $20,000 in negative equity would require the seller to bring that amount to closing.

Refinancing an asset with negative equity can also be challenging or impossible. Lenders generally require a certain amount of equity, often preferring a loan-to-value (LTV) ratio of 80% or less, to approve a new loan.

Despite the financial inversion, the asset itself remains usable for its intended purpose; a car can still be driven, and a home can still be lived in. The immediate impact of negative equity primarily affects an owner’s financial flexibility and their ability to sell or refinance the asset without incurring additional costs.

Actions to Consider with Negative Equity

When facing negative equity, individuals have several approaches to consider for managing the situation. For many, simply continuing to make regular payments on the loan is a common strategy. Over time, the loan balance will gradually decrease through scheduled principal payments, and the asset’s market value may recover, eventually resolving the negative equity.

Making additional principal payments can accelerate the process of building equity and reducing the loan balance. Even small, consistent extra payments can shorten the loan term and help the loan balance fall below the asset’s value more quickly.

If selling the asset becomes unavoidable, options exist to address the shortfall. One approach involves bringing cash to closing to cover the difference between the sale price and the outstanding loan balance. Another consideration is a short sale, where the lender agrees to accept less than the full loan amount to facilitate the sale. While a short sale can prevent foreclosure, it typically has a significant impact on credit, potentially lowering scores by 50 to 150 points and remaining on credit reports for up to seven years.