Negative equity
Encyclopedia
Negative equity occurs when the value of an asset used to secure a loan is less than the outstanding balance on the loan. 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.
. 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 repossession
s 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.
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.
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
, whose loans are mortgages
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
) 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.
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 amortizationNegative amortization
In finance, negative amortization, also known as NegAm, deferred interest or graduated payment mortgage, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases...
. The typical assets securing such loans are real property
Real property
In English Common Law, real property, real estate, realty, or immovable property is any subset of land that has been legally defined and the improvements to it made by human efforts: any buildings, machinery, wells, dams, ponds, mines, canals, roads, various property rights, and so forth...
– commercial, office and residential. When the loan is nonrecourse
Nonrecourse debt
Non-recourse debt or a non-recourse loan is a secured loan that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the...
, 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
Real estate economics
Real estate economics is the application of economic techniques to real estate markets. It tries to describe, explain, and predict patterns of prices, supply, and demand...
, a fall in the market value
Market value
Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may differ in some...
of a mortgaged
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
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
Repossession
Repossession is generally used to refer to a financial institution taking back an object that was either used as collateral or rented or leased in a transaction. Repossession is a "self-help" type of action in which the party having right of ownership of the property in question takes the property...
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
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
during the economic recession between 1991 and 1996, and in Hong Kong
Hong Kong
Hong Kong is one of two Special Administrative Regions of the People's Republic of China , the other being Macau. A city-state situated on China's south coast and enclosed by the Pearl River Delta and South China Sea, it is renowned for its expansive skyline and deep natural harbour...
between 1998 and 2003. These recessions led to increased unemployment and a decline in property prices, which in turn led to an increase in repossession
Repossession
Repossession is generally used to refer to a financial institution taking back an object that was either used as collateral or rented or leased in a transaction. Repossession is a "self-help" type of action in which the party having right of ownership of the property in question takes the property...
s 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
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
, as they are most at risk from declines in property price.
Negative net worth
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 loanStudent loan
A student loan is designed to help students pay for university tuition, books, and living expenses. It may differ from other types of loans in that the interest rate may be substantially lower and the repayment schedule may be deferred while the student is still in education...
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
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
, 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 loanMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
s - Negative amortizationNegative amortizationIn finance, negative amortization, also known as NegAm, deferred interest or graduated payment mortgage, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases...
- Loss mitigationLoss mitigationLoss mitigation is used to describe a third party helping a homeowner, a division within a bank that mitigates the loss of the bank, or a firm that handles the process of negotiation between a homeowner and the homeowner's lender. Loss mitigation works to negotiate mortgage terms for the homeowner...
- Strategic defaultStrategic defaultA strategic default is the decision by a borrower to stop making payments on a debt despite having the financial ability to make the payments....
- Equity (finance)Equity (finance)In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...