by Dian Hymer
Equity is the difference between the value of your property and the amount you owe on it. If your home is worth $250,000 and the liens against it total $150,000, you have $100,000 in equity. When the liens total more than the property value, you have negative equity.
What can cause negative equity? If the amount of the loan(s) secured against a property is high relative to the property's value and then property values drop, you could end up with negative equity. Let's say you bought your home when home prices peaked in 1989, and you paid $200,000 using a $180,000 mortgage for 90 percent of the purchase price.
Later, prices in your area decreased by 20 percent. That left you with a property worth about $160,000. Since most of each monthly payment on a new mortgage goes to pay interest, very little principal (the amount borrowed) is paid back during the early years of home ownership. Even after several years, your remaining loan balance could be about $176,000--$16,000 more than the current property value. This is negative equity.
Even if you didn't buy when prices were high, you could unwittingly get yourself into negative equity if you refinance to a larger mortgage at a time when property values are high and then values drop.
Adjustable rate mortgages (ARMs) with payment caps can also lead to negative equity if the borrower permits negative amortization to occur. When an ARM has a payment cap, it limits how high the monthly payment can go each time the interest rate adjusts upwards.
If the interest rate on your ARM goes up and the new capped monthly payment is insufficient to pay the interest owed for that month, the unpaid interest is added to the remaining mortgage balance. In this case, the mortgage gets bigger, not smaller, with each monthly payment. This is called negative amortization. Negative amortization can lead to negative equity, particularly if the loan balance is high relative to the property value.
You can avoid negative amortization by paying enough each month to cover the additional interest owed (a fully amortizing or interest-only payment).
First Time Tip: In a positive equity situation, the sale price of a home is sufficient to pay off the property liens and the seller's closing costs (commission, transfer taxes, etc.). There's often enough left over for a down payment on another home.
How does a homeowner with negative equity sell? Owners with enough cash reserves to pay the negative equity and closing costs can complete a conventional sale. But homeowners who don't have resources to make up their shortfall should talk with their lender about doing a short-sale.
With a short-sale the lender agrees to accept less than the amount owed on the mortgage so that the home can be sold. For example, due to the decline in property values, an Oakland home recently sold for about $35,000 less than the remaining loan balance. The sellers were able to borrow $10,000 on an unsecured loan in order to pay their lender part of their shortfall. The lender agreed to accept $25,000 less than the amount owed so that the sale could go through.
Another option is to let the lender foreclose on the property. A disadvantage of this is the adverse effect it will have on the defaulting homeowners' credit. It could be difficult to get another mortgage soon.
The Closing: The short-sale sellers in the above example had a stellar record of making their monthly mortgage payments--they were not in default. Consequently, the short-sale won't adversely affect their credit.
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