Negative Equity

Negative equity is the situation in which the market value of an asset is lower than the debt secured against it. The term is used mostly for housing: a homeowner whose house is worth 250,000 but who still owes 280,000 on the mortgage has negative equity of 30,000. In American usage the borrower is said to be "underwater". The same idea applies to car loans and, on a company's balance sheet, to a business whose liabilities exceed its assets.

Negative equity usually follows a fall in prices after a period of high borrowing, and it is closely tied to leverage, the use of borrowed money to buy an asset: the smaller the deposit, the smaller the price fall needed to wipe out the owner's stake. It does not by itself mean a borrower will stop paying. Many households in negative equity keep up their payments and wait for prices to recover. The risks appear when they need to sell, move or refinance, or when their income falls at the same time.

Imagine buying a bicycle on credit and, a year later, finding that the bike would sell for less than the amount still owed on the loan. Selling it would not clear the debt; you would have to find the gap from your own pocket. That gap is negative equity.

With a home, the gap can be large, and it often appears because prices across a whole area fall, not because of anything the owner did. As long as the owner can keep paying and does not need to sell, the problem can be lived with. It bites when life forces a move.

Home equity is the market value of the property minus the outstanding loan. Lenders usually express the same idea as a loan-to-value (LTV) ratio:

• $L$ is the loan balance outstanding.
• $V$ is the current market value of the property.
• An LTV above 100 means the owner is in negative equity.

A buyer purchases a home for 300,000 with a 10% deposit, borrowing 270,000, an LTV of 90%. If prices in the area fall by 15%, the home is worth 255,000. Equity is now $255{,}000 - 270{,}000 = -15{,}000$, and the LTV is $270{,}000 \div 255{,}000 \times 100 \approx 105.9$. The owner would need to find 15,000, plus selling costs, to sell and repay the loan in full.

Negative equity has featured in most major housing downturns, usually after an economic bubble in property.

• United Kingdom, early 1990s. After the late-1980s boom, high interest rates and recession pushed house prices down, leaving well over a million households in negative equity at the peak of the slump, according to Bank of England estimates.
• United States, 2006 to 2012. The collapse in house prices that led into the 2008 financial crisis left a large share of mortgaged homes underwater; private estimates put it close to a quarter around 2009 to 2011, with the deepest pockets in states such as Nevada, Arizona and Florida, where sub-prime lending had been heavy.
• Ireland and Spain after 2008. Steep property falls left many recent buyers in negative equity for years.

Policy responses have included programmes to let underwater borrowers refinance at lower rates, such as the US Home Affordable Refinance Program launched in 2009, and loan modifications that reduce payments. Negative equity is one part of the boom and bust pattern in property markets.

• Higher default risk. Negative equity alone rarely causes default, but combined with job loss or rising payments it removes the owner's option to sell and clear the debt. Researchers call this the "double trigger".
• Strategic default. Where loans are non-recourse, as in some US states, an underwater owner can hand the home back without owing the shortfall, and some do so even when they could pay. In the UK and most of Europe, mortgages are full recourse and the borrower remains liable.
• Lock-in and mobility. Owners who cannot sell without a loss may stay put rather than move for work, which some economists argue reduces labour market flexibility.
• Spending. Falling home equity reduces household wealth and borrowing capacity, which can weigh on consumption through the wealth effect.
• Bank losses. Loans with LTVs above 100% produce losses if they default, adding to non-performing loans and making lenders more cautious.

Car buyers often have negative equity early in a loan because new vehicles lose value quickly. Dealers sometimes roll the shortfall into the next loan, which raises the amount owed on the replacement car.

For companies, negative equity, also called a shareholders' deficit, means total liabilities exceed total assets on the balance sheet, so book net worth is below zero. It can signal distress, with shareholders at the back of the queue set by debt seniority. It can also arise in healthy, profitable firms that have borrowed to buy back large amounts of their own shares; several large US companies, including McDonald's, have reported negative shareholders' equity for years while remaining highly profitable.

• Bank of England
• Consumer Financial Protection Bureau