What’s Wrong With Negative Equity?

October 22, 2008

Someone recently asked me: “What’s wrong with negative equity? Assuming prices eventually recover, can’t you just sit tight?”


The problem with negative equity–owing more on a property than it’s worth–comes only if the owner of the property wants to/needs to sell or refinance the property. Let’s say, for example, that someone bought a property a while back for $200,000 and put 10% down. That means the person put $20,000 down and started off with a $180,000 mortgage.

But prices in many areas have declined. Let’s say that property–originally worth $200,000–is now worth only $175,000. If the owner tries to sell, after real estate commissions and other expenses, he’ll receive perhaps $160,000. But he still owes about $180,000 on his mortgage. So, for the sale to work, he’d need to bring $20,000 to closing to pay off his lender. Some people can do that. A lot of people can’t.

Similarly, the owner might want to refinance. Many buyers in the past couple of years chose some sort of adjustable rate mortgage (ARM) with a rising interest rate. Maybe they even started out with a negative amortization loan, meaning they now owe more than they did when they bought the house. In either case, they’d like to refinance to a nice, conventional, fixed-rate loan. But it takes equity to refinance, and if you owe $180,000 on a house that’s only worth $175,000, no lender will refinance the mortgage.

The picture’s quite different, though, if you don’t have to sell or refinance. True, you put $20,000 down on a $200,000 property. The property’s only worth $175,000, but you owe $180,000 on it. Not the ideal situation. Still: If you can afford the payments and don’t have to sell, so what? You have an affordable place to live. On paper (only on paper) you’ve lost $25,000. In practice, you own a property and you’re making payments on it.

Let’s say the housing market declines for another year or two, then slowly comes back. In five years, your house is worth $200,000. You’re back to where you started. Values keep climbing. Not like a few years ago, but they do go up. And so in 10 years, your property is worth $275,000. Nobody has a crystal ball, but that’s a possible scenario.

So, where are you in 10 years? If you sell, let’s assume all the transaction costs (real estate commissions and other costs) are 9% of the value of the property, or $24,750. So your net (sales price minus other costs) would be about $250,250.

Meanwhile, that $180,000 mortgage (with a 30-year fixed rate loan of 6%) would be paid down to about $150,000. So you’d walk away from closing with a check for roughly $100,250 ($250,250 minus $150,000). That works out to a gain of $80,250 on an investment of $20,000. That’s a total return on investment of 401%, or a simple annualized return of 40%.

Again, no one has a crystal ball. And there are various tax and other implications involved, and I’m not an accountant.¬†Further, we don’t know what’s going to happen to the real estate market. But the point is: Negative equity alone doesn’t mean a thing so long as you don’t have to sell or refinance. Sit tight. Make your payments. Don’t worry about paper losses. And you’ll do OK.