Understanding negative equity

Negative home equity occurs when the amount of your home loan exceeds the dollar amount your home is worth on the market. Loans are not set up in negative equity situations, but there are a number of factors that can flip equity upside down. Understanding how this happens can help you make smarter decisions when financing your home. It can also help you understand your options for getting out from underneath home equity that is currently upside down.

Traditionally, when a buyer enters the housing market, he or she secures a loan that is no more than 80% of the current value of the home being purchased. This keeps the risk level of the lender manageable and the investment sound for the borrower.

A number of factors, including a fluctuating housing market and variable home loan interest rates, can alter the loan-to-value ratio - even at times pushing it higher than 100%. When this happens, the borrower is said to have negative equity in his or her home.

Since banks are not willing to loan money that exceeds the value of the home it is being used to purchase, you might be wondering how a homeowner could find himself with negative equity. The causes of negative home equity can either be the result of lending requirements that are too lenient or a change in the housing market. They include:

• Buying a home during a market peak when prices are artificially high and then dramatically drop
• Borrowing against the home with a home equity loan and then experiencing a decline in the market
• Securing a high-interest loan with minimal amounts applied towards loan principal
• Putting too minimal of a down payment on your home at the time of purchase

Negative home equity puts the homeowner in a predicament if he or she is looking to sell. Prospective home buyers will only be able to secure a home loan for the current value of the home on the market, not for the amount that is owed by the lender. This limits the potential number of buyers for the property and can mean the buyer is "trapped" in the home.

A homeowner with an upside-down mortgage has a handful of negative equity options if he is looking to move forward.

1. Sell and pay off the negative equity at the time of sale.
2. Rent the property until market value increases or you pay the loan down to a point where equity is positive
3. Stay in your home and create a plan to make payments to reverse the negative equity situation
4. Investigate the availability of "forgiveness" plans and negative equity refinancing options

Securing a loan against negative equity can be difficult; however, if you are struggling with negative home equity but still have a positive credit history you may have more options.

During a drop in the housing market, the government may step up to provide negative equity options to borrowers struggling to get back on their feet. These loans can increase loan-to-value ratios above 100%. In other words, a borrower with a home valued at $150,000 could potentially secure a loan that is greater than that amount by a specific percent. Negative equity refinancing loans are typically offered at low interest rates and are designed to help borrowers get back into a positive equity situation in lieu of defaulting on their homes.