Negative equity is a situation that occurs when an asset's value dips below the outstanding balance on the loan used to purchase it. A classic example of negative equity occurs in the housing market when people have mortgages that are worth more than their homes. There are several ways that people can end up in this situation.
One way to create negative equity is to have a loan repayment plan that allows for negative amortization. In this type of repayment plan, people are not paying enough on the loan to cover the interest, let alone the principal. Each month the interest is compounded and added to the balance of the loan, causing the amount of the loan to increase. If the value of the asset stays the same, negative equity is created.
Neg-am loans, as they are known, are usually designed to reset at some point in the future. After a period of time on the original repayment plan, people will begin paying more to pay the loan back. This type of loan can be advantageous for some situations, and is most commonly seen when people buy real estate in anticipation of a rise in value. These buyers hope to sell or refinance the real estate at a profit to pay off the loan and pocket the difference between the sales price and the final loan balance.
Another situation that can lead to negative equity is a depreciation of the asset. This can occur with car loans, where people may have loans with long terms that end up being worth more than the vehicle at some point during repayment. With home loans, drops in the real estate market can cause a house to depreciate below the value of the loan.
When negative equity occurs, the term “upside down” is used to refer to the situation, as usually the difference between the loan and the value of the asset is the other way around. The asset itself is considered “underwater.”
When assets become underwater, people have a number of options for dealing with it. Some borrowers may continue to pay on the loan in the hopes that the asset will appreciate in value or in the interests of keeping their credit histories clean. Others may attempt to renegotiate the loan to see if it is possible to get better terms or to reduce the principal. Another option is to talk away from the loan, surrendering the asset to the lender and taking the subsequent hit to credit history.
