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What Is Negative Equity On Your Mortgage?

7-minute read

“Equity” is a term that refers to the amount of your home that you own. In most circumstances, your home equity increases over time as you make payments on your loan. But if property values fall, you may find yourself with no equity or even negative equity.

We’ll talk about how negative equity can occur and how you can avoid it. We’ll also go over the options you have if you have negative equity in your home.

How Does Negative Equity Occur?

Negative equity occurs when the value of an asset you own is less than the outstanding balance on the loan. You may hear a lender refer to a loan with negative equity as “underwater” or “upside-down.” But wait – since most lenders won’t loan you more money than your home is worth, how is negative equity possible?

Let’s say that you want to buy a home worth $150,000 and you have a 10% down payment of $15,000. You visit a lender, close on your loan and take on a mortgage worth $135,000. The day you close on your loan, you have $15,000 in equity – you’ve paid your lender $15,000 and your home is worth $150,000.

Fast forward a year and your local housing market has taken a negative turn. Though you’ve only paid another $1,000 off your loan principal, your home is now worth $120,000. However, your original loan that you took when home prices were higher is still in place, and you owe your lender $134,000. In this example, you have $14,000 in negative equity because you owe your lender $14,000 more than your home is worth.

A few different things can cause negative equity: 

  • Buying a home when market prices are high and then seeing local prices fall.
  • Putting a down payment on your home and then seeing local prices fall.
  • Missing payments very early in the term of your loan and allowing interest to accumulate.

Negative equity can cause a few problems for you as a homeowner. You may have a tough time getting a refinance because lenders can’t loan out more money than your property is worth. In this example, you could only refinance up to $120,000 of your home loan because that’s what your home is worth. You’d need to pay off your negative equity before you qualify.

You may also have trouble selling your home. When you sell your home, you typically use the money from the sale to pay off your existing mortgage. If there’s still an outstanding balance after the sale, you need to cover it before your lender closes your loan.

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How To Avoid Negative Equity

No homeowner wants to experience negative equity. Here are a few precautionary steps you can take to avoid this.

  • Consider current market prices. The best way to avoid negative equity is to buy a home that’s set to increase in value over time. When the value of your home increases as a result of market conditions, you gain equity without making extra payments. Consider talking with a real estate professional before you buy a home to make sure that market conditions are ideal.
  • Put more money down. You no longer need a 20% down payment to buy a home, but a down payment that’s too small can harm your equity. For example, if you take out a VA loan with no money down and your local housing market takes a negative turn, you’ll fall into negative equity almost immediately. Avoid this situation by saving a larger down payment or buying a more affordable property.
  • Don’t buy more home than you can afford. Falling behind on your payments early in the course of your loan can cause you to build negative equity very quickly. Make sure you consider all of the costs of owning a home before you sign on a loan.

Can You Reverse Negative Equity?

What should you do if you have negative equity on your property? Though there is no surefire way to reverse negative equity, you do have a few options to lessen your burden. Let’s take a look at some of them now.

Continue Making Payments

Every time you make a payment on your home loan, you gain a small amount of equity in your property. Once you fully own your home, you have 100% equity in your property. You can continue to make payments on your loan if you’re comfortable in your home and you can manage your payments. When home values rise again, you can eventually sell or refinance your home once your equity is out of the negative.

You may want to consider making permanent home improvements while you make payments. Improvements increase the value of your property and can help you fight against negative equity. Some examples of improvements that you can make to improve your home’s value include:

  • Replacing large appliances with newer models.
  • Adding a home security system.
  • Replacing old, worn-out cabinets in the kitchen.
  • Adding a patio to your backyard.

Remember that only permanent improvements count toward your home’s value. Purely aesthetic changes (like painting a wall) and temporary improvements won’t improve your equity.

Refinance Your Loan

Are you having trouble making payments on your loan? You might want to refinance. When you refinance, you replace your old mortgage loan with a new loan that has more manageable terms. A refinance can allow you to lower your monthly payment by taking a lower interest rate or by lengthening your term. A refinance won’t improve the value of your home, but it can help you avoid foreclosure while you wait for local home values to rise.

Refinancing a home loan with negative equity is more complicated than a standard refinance. Under most circumstances, a lender cannot loan you more money than your home is worth. This means that if your home has negative equity, your lender might require you to bring cash to closing to make up the difference. Unfortunately, most homeowners don’t have thousands of dollars in the bank to pay the lender in a lump sum.

There are a few special programs that you may be able to use to refinance a loan with negative equity. You may be able to use Fannie Mae’s High Loan-To-Value Refinance program if you have a conventional mortgage. A High LTV Refinance can allow you to refinance a loan when you owe more money than your home is worth.

All of the following must be true to qualify for a High LTV Refinance:

  • Fannie Mae must own your loan. Check to see if Fannie owns your loan using Fannie Mae’s search feature.
  • You must be current on your mortgage payments.
  • There must be at least 15 months between the note date of your original mortgage and the note date of your High LTV Refinance.
  • The note date of your refinance must be on or after October 1, 2017.
  • You must not have refinanced your mortgage with HARP, a now-defunct mortgage relief program.

Freddie Mac’s version of the High LTV Refinance is the Relief Refinance. Like a High LTV Refinance, a Relief Refinance can help you refinance a loan even if you have negative equity.

All of the following must be true to qualify for a Relief Refinance:

  • Freddie Mac must own your loan. Use Freddie’s Loan Lookup Tool to find out if Freddie owns your loan.
  • You must be current on your mortgage payments.
  • Your note date of your refinance must be on or after October 1, 2017.
  • You may not have used HARP to refinance your loan in the past.

Do you have an FHA loan? You may be able to refinance with an FHA Streamline. An FHA Streamline refinance is unique because it skips the standard appraisal requirement. This means that your lender doesn’t need to know how much your home is worth before you can refinance. FHA Streamline refinances also involve less paperwork. You can even skip the credit check and employment verification in some cases.

All of the following must be true to qualify for an FHA Streamline refinance: 

  • Your loan must already be an FHA loan.
  • There must be at least 210 days between when you closed on your FHA loan and the date you close on your Streamline refinance.
  • You need to be current on your mortgage loan and you cannot have any missed payments on your record in the last 6 months.
  • Your refinance needs to offer a tangible net benefit – in other words, the Streamline must benefit you in some way. This can include a lower interest rate or a lower monthly payment.

Do you have a VA loan? You may qualify for a VA interest rate reduction refinance loan. You can refinance up to 120% of your loan value with a VA IRRRL, which makes it a great choice for homeowners with negative equity.

All of the following must be true to qualify for a VA IRRRL:

  • You must already have a VA loan.
  • There have been at least 270 days since you closed on your VA loan.
  • You’ve made at least 6 consecutive on-time payments.
  • You currently live in the home you’re refinancing, and you plan to continue living there.

Contact your lender if you think you qualify for a Relief Refinance, High LTV Refinance, Streamline refinance or VA IRRRL.

Sell Your Home

Negative equity doesn’t technically stop you from selling your property. But remember that mortgage lenders can’t close your loan until you pay off the entire balance of the outstanding loan. This means that if you can’t sell your home for at least enough to cover your current mortgage, you’ll need to pay your lender the rest in cash.

This can be tough, especially if you have a large amount of negative equity. However, if you have reason to believe that property values will continue to decrease in your area, downsizing might be the right choice for you. Consider talking to a Home Loan Expert or another real estate professional before you decide to sell when you have negative equity.

Summary

Negative equity occurs when you owe more money on your home than your home is worth. Falling local property values and missed payments can cause negative equity. This is a problem because it can make selling your home or refinancing more difficult. You can avoid negative equity by buying a home when market prices are low, putting more money down and buying a home you can afford. You can also wait until property values improve, you can refinance or you can sell your home and pay your lender the difference.

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