How Negative Equity Affects Foreclosure

Negative equity in a home simply means the homeowner owes more on a mortgage than a home's current market value. This typically happens when home values drop sharply immediately after a homeowner has taken a new mortgage. The home owner has not had the chance to pay a sufficient amount of the mortgage. The result is an "upside down" or negative equity arrangement. This situation is one of the leading causes of foreclosure, but lenders do not like foreclosing on negative equity homes.

How Negative Equity Leads to Foreclosure

When a person owes more on a home mortgage than the home is worth, there is a strong indication the mortgage was a bad deal for the borrower. Many of these situations involve "interest only" mortgage arrangements, where a borrower makes only interest payments instead of paying down the principal. Other homes were financed with "sub-prime" mortgages; this means loans were extended at rate below the national prime rate and then adjusted to a very high interest. It is also possible a home was simply over-valued at the time of purchase.

In any of these scenarios, the borrower will likely want out of the mortgage deal. However, selling the home would not cover the cost of paying the mortgage. While refinancing may be an option, these borrowers tend to have bad credit scores preventing them from getting a better loan. Many will instead opt to stop making mortgage payments and look for a short sale opportunity. Other borrowers will have no choice but to stop making payments and the home will move into foreclosure. 

Why Lenders Don't Like Negative Equity

Lenders do not like negative equity foreclosure proceedings. If retain the deed to the home after the foreclosure and then sell the home, they will not earn as much as they would have if the borrower paid off the mortgage in full. Further, it is possible they will net a loss on the situation. The lender originally paid the initial value of the home to the seller. They need to make that money back, plus interest, in order to just break even. Only if the interest is high enough will they profit.

In a situation where the lender is recovering an asset that is not worth the original valuation used when the asset was placed as collateral, the lender will end up losing money. Lenders are not likely to respond positively to borrowers who aim for a short sale or foreclosure on a negative equity property.

How Regulators may Resolve the Situation

One of the considerations that regulators are working on is assisting with this problem by purchasing the home out of foreclosure. They then issue the original lender a "certificate of negative equity." The homeowner begins making payments to the FHA or government regulator; those payments are lower because the government will be willing to refinance the loan to qualified buyers. Then, if the government does end up foreclosing and selling the home at a higher rate, the original lender can present the negative equity certificate to attempt to collect the funds it lost in the deal.