What’s Wrong With Negative Equity?

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

Absolutely.

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.