Negative Equity

Negative equity arises from the fundamental mismatch between asset depreciation and loan amortization. When you finance a vehicle, the loan balance decreases according to your amortization schedule — a fixed monthly payment that applies a portion to interest and a portion to principal. In the early years of a loan, the vast majority of each payment goes toward interest. For example, on a $40,000 loan at 7.5% APR over 72 months, only about $380 of the first $690 monthly payment goes to principal, while $310 is interest. Meanwhile, the vehicle depreciates at an average rate of 15% to 20% in year one, 10% to 15% in year two, and 8% to 10% in year three. Because depreciation outpaces principal reduction in the early years, most borrowers who put down less than 15% to 20% on a new car will experience negative equity at some point during the first 12 to 24 months. Longer loan terms amplify the problem: an 84-month loan amortizes so slowly that the loan balance may not dip below the vehicle's depreciated value until month 36 or later.

In mortgage lending, negative equity occurs when local housing markets decline by 10% or more and the homeowner had a small down payment. During the 2008 financial crisis, 23% of U.S. homeowners with mortgages were underwater at the peak, with an average negative equity of $75,000 according to data from CoreLogic. Negative equity in homes is particularly pernicious because real estate transaction costs are high — selling a home typically costs 5% to 6% in real estate commissions plus closing costs, which adds another $20,000 to $30,000 in costs on a $400,000 home. This means even a homeowner who is only slightly underwater must come up with significant cash to sell. Negative equity can be resolved by making additional principal payments, waiting for the asset to appreciate (in real estate) or for the loan to amortize below the asset value, or by bringing cash to sell the asset. In extreme cases, homeowners may pursue a short sale, where the lender agrees to accept less than the full loan balance, but this damages credit by 100 to 130 points and requires documented financial hardship. A deed in lieu of foreclosure is another option where the borrower voluntarily transfers the property to the lender, avoiding the full foreclosure process but still severely impacting credit.

Negative equity traps borrowers in financial situations that limit their options. If you are underwater on a car loan and your circumstances change — you lose your job, need a larger vehicle for a growing family, or the car requires expensive repairs — you cannot simply sell the car to get out of the loan without writing a substantial check. Rolling negative equity into a new auto loan, sometimes called rolling over or being "upside down all over again," is possible but creates a cycle of debt where each loan starts with a balance higher than the asset's value, increasing the risk of default and repossession. Lenders typically cap the amount of negative equity that can be rolled into a new loan at 110% to 125% of the new vehicle's value, and the interest rate on the new loan will be higher. In mortgages, negative equity prevents refinancing because lenders require a maximum 80% LTV for most rate-and-term refinances; underwater homeowners are locked into their current rate unless they qualify for government programs like HARP (now expired) or FHA Streamline refinances.

Negative equity also increases the risk of strategic default and foreclosure, which can destroy a borrower's credit for seven years and make it nearly impossible to obtain future credit at reasonable rates. The best defense against negative equity is a substantial down payment (at least 15% for a vehicle, 20% for a home) and shorter loan terms that build equity faster. Gap insurance is another important tool for auto borrowers who are at risk of negative equity. If your car is totaled in an accident, standard auto insurance pays only the actual cash value of the vehicle, which may be less than your loan balance. Gap insurance covers the difference between the insurance payout and the loan balance, protecting you from having to pay thousands of dollars out of pocket for a car you no longer have. Many lenders require gap insurance for loans with LTV above 100%, and it typically costs $200 to $700 as a one-time premium or $5 to $10 per month added to your payment.