Buying a home? Learn how negative equity can become your worst nightmare.

by Chris Lang on September 14, 2009

Your mortgage is not my problemAre you familiar with the term “negative equity”? If you aren’t, you’ll think it sounds a little bit strange, lacking logic even – how can equity be negative? And you know what – you’re right, this term describes a situation that doesn’t make sense. But IMHO we are very close to getting into that kind of situation, which is why I am writing this post.

First let me explain what negative equity is, and then you will understand why you should never ever get stuck with it. One’s house becomes a negative equity when they owe the bank more than house is worth. Any house with a mortgage worth more than the house itself becomes a negative equity.

Why is this a dangerous situation to be in? Well, imagine that you need to sell that house and move elsewhere. You’ll sell it and won’t be able to pay off the mortgage, so you will have no place to live and will still owe the bank money. Not a good place to be.

But how can that situation happen in the first place? I mean banks are not stupid, and they lend you money against your house’s value. They send a trained professional to do property evaluation, to be sure your house is worth more than they lend you.

Here is one scenario: imagine a bubble when houses are way too overpriced. Does that sound familiar? Does it remind you of our current property market? Anyway, when property valuers perform the evaluation, they take into account the features of the house, but they never operate in vacuum – they also take into account prices on property in the neighborhood. This means that when other houses in the same street went up in price for no good reason, other than craziness of people who overpay – the house you’re buying went up in price, too.

So the bank feels it’s safe to lend you the 300K for you to buy a house and you begin to pay off your mortgage. You’re not in a hurry because you’ve got the next 20 years to do it. And then the bubble bursts. Just like it did in the US.

And houses decline in value. And the house you’ve bought isn’t worth 300K any more, it has lost 15% of its value. Or, more accurately, it was overpriced 15% when you bought it and now, after correction has occurred, it’s back to its realistic price. Which still is 15% less than you owe the bank. Which means that if you’ll sell it and every cent you get for it goes to the bank, you will still owe 45,000. Which is about the annual wages worth for many people I know.

This story shouldn’t scare people who have a lot of confidence in their jobs. If loss of income isn’t likely to make you sell the house in then next 2 years, don’t worry about negative equity. If you’re positive there is no reason in the world why you would want to sell and move in the next couple of years – go for it, buy if you want to. If you’re not borrowing 80+ percent of your house, you will survive the fall.

Otherwise… consider yourself warned.

{ 5 comments… read them below or add one }

Chris September 16, 2009 at 11:33 pm

I’ve just been featured in Money Hacker Carnival, head there for some interesting reads.

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stephanie September 17, 2009 at 12:28 am

if you’re in a negative equity position, apply to have your property taxes lowered – surely the assessed/appraised value used to calculate your taxes must also be lowered.

hang in there.

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Tim Hawkins September 20, 2009 at 3:16 pm

So, how is a negative equity situation if the homeowner doesn’t have to move and has a great job?

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Chris September 20, 2009 at 6:21 pm

If a homeowner has the time to wait until the property market gets back up, then no harm is done and he will be owning a home that is worth the mortgage. The only thing is no one knows how long such recovery takes.

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Alex December 3, 2009 at 8:54 am

Another problem of negative equity – the bank may require to put some money to cover the gap. This happened in Singapore and other places.
Whether you would have enough spare cash to cover it or have to sell and be left with a debt…Neither option is pretty.

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