Negative Equity

Negative equity is the rare situation whereby the balance on the mortgage is more than the value of the house.

However, with what we’ve witnessed in 2008, negative equity are no longer seen as exceptions these days.

Don’t get me wrong. They are still uncommon.

But people are no longer surprised when they see others getting into the sticky situation.

The main cause of this is the result of plummeting real estate value.

So much so that the pace of depreciation in value is much faster than the reduction in the loan principal as it is paid down by the borrower.

Another common way homeowners fall into negative equity territory is when they first take on a 100% financing loans.

This is because the total loan amount of such financing structures will include the property purchase price plus points and other expense items in closing costs.

Assuming the value of the property in question is equal to the purchase price, the borrower will have negative equity from the commencement of the loan.

It goes with saying that calculating return on equity will be pointless at this point.

However, they should be able to go into positive after a few monthly payments… unless the real estate market crashes in the mean time.

Negative equity encourages certain borrower behavior

During a period in 2009 when negative equity was widespread, many borrowers simply refused to pay their mortgages because their money will only go into alleviating the negative equity instead of helping them build equity in their homes.

And they are not able to refinance their home loans as lenders would be crazy to refinance a house for more money that it’s worth.

This brought about a rise in defaults.

Another behavior that was observed was that because sales proceeds from the sale of a house will not be able to pay off the liens on it, many homeowners were unable to relocated as they simply don’t have the funds needed to retain a good title.

Liens are after all, non-transferable.

Actually… they are. But one would need a miracle to get a lender to agree to it.

This meant that many homeowners were either trapped with their existing homes, or became tenants of the new area they intended to relocate to while keeping the old house as a landlord.

Finally, playing the appreciation game in real estate investing can put you in greater exposure to negative equity risks.

So do run your numbers before investing like a maverick.

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