What is negative equity and how does it work?

Negative equity means you owe more on your loan than the current value of your asset. The term is also commonly applied to cars. But it’s particularly distressing when applied to your home. Luckily, there are actions – and inactions – you can take to lessen the impact.

What is the meaning of negative equity?

If you purchase a home or a car, you own it immediately. Sure, you might have taken out a loan to help buy it, but one of the most gratifying milestones is when that loan is paid off. This brings with it the feeling of true ownership. It’s yours until you sell it.

Equity is the difference between the value of an asset and the balance on the loan you took out to pay for it. In most cases, home equity increases over time, both as you make payments and is your property value rises. You end up with positive equity.

When property values fall, you may be left with no equity or negative equity in your home because it’s worth less than what you owe your lender. This is also more common with cars because they depreciate quickly once you drive them off the dealer lot. Having negative equity is also referred to as being “underwater” or “upside down on the loan.”

How do you calculate negative equity?

Negative and positive equity are calculated the same way: Subtract your remaining loan balance from your property value. If the result is negative, you owe more on your home or car than it’s worth.

How this applies to mortgages 

One scenario that may result in negative equity is when home prices fall.

Let’s say you bought a home worth $300,000 and took out a $285,000 loan. A year later, your local real estate market has experienced a downturn. Homes selling for less than they were before has had a detrimental effect on your property value.

Your home is now worth $270,000 instead of the $300,000 you originally paid, and you owe your lender a little more than $281,000 after making a year’s worth of payments on your 30-year term. In this scenario, you would have around $11,000 in negative equity because you owe your lender about $11,000 more than your home is worth.

The good news is in today’s real estate climate, this is a relatively rare circumstance. In CoreLogic data for the third quarter of 2024, only about 1.8% of all mortgaged properties were considered to be underwater.

How this applies to car loans

With the exception of certain cars that become objects of desire for collectors, most vehicles never have more value than before someone ever takes possession from the dealer. For this reason, car loans end up having negative equity much more commonly than home loans.

Let’s say you buy an SUV for $40,000, taking out a $38,500 loan. A year later after you put 20,000 miles on the car, it’s worth $30,000. With a 5-year loan, your balance would be about $31,100 at the end of the first year. This would mean being underwater on the loan by about $1,100.

If you’re doing a new purchase or lease with a dealer, it’s common for them to pay off your remaining payments early if you’re close enough to the finish line. But you should know that you’re often just refinancing the existing debt because the dealer may build it into your new loan.

What can cause negative equity?

Negative equity can occur in several ways. Here are a few examples of how it can happen to your home:

• Home prices fall shortly after you move in.
• Missing payments early in your loan term can mean your interest and fees rise precipitously.

Negative equity can cause several problems for homeowners, including difficulty refinancing to take advantage of more favorable terms. Lenders can’t loan more than the home is worth. Depending on your current mortgage, you may have an option to refinance, but this isn’t always the case.

You may also find it challenging to move. When you sell your home, you typically use the sale proceeds to pay off your existing mortgage. If there’s an outstanding balance after the sale, you would need to pay off the difference with cash. If you show a hardship, your servicer may approve a short sale. But you should know this has a negative impact on your credit.

How to avoid negative equity

It’s best to avoid negative equity if you can. We’ve got a few tips. Some of the same advice we give here is going to apply if you’re already in a negative equity situation. We’ll do a short list here and expand on these in the next section:

• Continue making payments.
• Make home improvements to raise your property value.
• Look into mortgage options that let you refinance regardless of your equity.

What can you do to reverse negative equity?

Negative equity is tricky and quick relief isn’t always possible, but there are steps you can take to alleviate the issue.

Continue making payments

Every time you make a mortgage payment, you lower your mortgage balance. Eventually, this can help you get back on the right side of the equity equation. If you can afford it, consider making extra payments on the loan to bring your total loan balance down faster. When home values rise again, you can eventually sell or refinance your home.

Make home improvements

Making permanent home improvements can increase the value of your property, which may help you turn the tables when facing negative equity. These improvements should be both meant to last and tangible in nature. Changes to the aesthetics of your home – like painting – or temporary installations won’t impact your property value.

Some examples of improvements that can increase a home’s value include:

• Replace large appliances with newer models.
• Add a home security system.
• Replace old, worn-out cabinets and fixtures in the kitchen.
• Update your bathroom. The kitchen and bathroom are two areas that prospective home buyers pay a lot of attention to, so upgrades here can really pay off.
• Install a patio or deck in your backyard.

Refinance your loan

When you refinance a mortgage, you do so to secure more favorable terms or turn existing equity into cash. While you can’t cash out equity you don’t have, a change in your rate or term could provide payment relief.

While most refinancing options require some amount of existing equity, an FHA or VA Streamline – also known as a VA Interest Rate Reduction Refinance Loan (IRRRL) – allow you to refinance regardless of property value in many instances.

Not only is there the potential for a lower rate and payment, there are lower mortgage insurance and funding fee requirements. You must have an FHA or VA loan to qualify.

The bottom line

Negative equity occurs when you owe more money on your home than your home is worth. Falling local property values, missed early mortgage payments and snowballing interest payments can lead to negative equity. And negative equity can make selling or refinancing your home more challenging. To safeguard your real estate investment from negative equity, try buying a home when market prices are low, putting more money down or buying within or below your house buying budget max.

Ready to refinance your home? Explore your options and begin the approval process today with Rocket Mortgage^?.