What Is Negative Equity on a Loan?

Negative equity happens when the value of an asset, like a car or home, is less than the remaining balance on the loan used to buy it. This is also known as being “underwater” or “upside down” on a loan. It can make selling or refinancing difficult because you may owe more than the asset’s worth. A financial advisor can help you understand how a large loan may impact your long-term financial goals.

How Negative Equity Works

Several factors can lead to negative equity. And this situation can make it difficult to sell or refinance that asset, as the sale proceeds might not be enough to pay off the loan balance.

In the housing market, a decline in property values can quickly erode equity. For car owners, rapid depreciation is a primary cause, often exacerbated by high-interest personal loan rates or extended loan terms. Additionally, borrowing more than the asset’s worth at the time of purchase, such as through zero-down payment offers, can increase the risk of negative equity.

For those with homes, negative equity can restrict the ability to sell or refinance a mortgage , potentially trapping them in a property that no longer meets their needs or financial situation. This can be particularly problematic if a homeowner needs to relocate for work or personal reasons.

Car owners facing negative equity may find it difficult to trade in their vehicle for a new one, as they would need to cover the shortfall between the car’s value and the loan balance. This situation can lead to financial strain, especially if the vehicle requires costly repairs or maintenance.

How to Determine If You Have Negative Equity

To determine if you have negative equity, start by assessing the current market value of your asset. For real estate, this might involve getting a professional home appraisal or comparing recent sales of similar properties in your area. For vehicles, you can use online resources like Kelley Blue Book or Edmunds to estimate the current market value.

Next, review your loan statements to find out the remaining balance on your loan. This figure should include any interest that has accrued and any fees that may apply. It’s important to have an up-to-date balance, as this will directly affect whether you have negative equity. If your loan balance exceeds the current market value of your asset, you are in a negative equity situation.

Several factors can contribute to negative equity. Market fluctuations, such as a recession , can cause asset values to drop unexpectedly, leaving you with a loan balance higher than the asset’s worth. Additionally, taking out a loan with a low down payment or opting for a longer loan term can increase the risk of negative equity.

Tips for Managing or Avoiding Negative Equity

Negative equity can be financially challenging, but there are strategies to manage or avoid it. Here are five common tips to help you navigate negative equity effectively.

• Make extra payments: Paying more than the minimum monthly payment can reduce the principal balance faster. This approach not only decreases the interest paid over time but also helps in building equity more quickly, reducing the risk of negative equity.
• Refinance your loan : If interest rates have dropped since you took out your loan, refinancing could lower your monthly payments and interest rate. This can make it easier to pay down the principal balance, potentially avoiding negative equity.
• Consider a shorter loan term : Opting for a shorter loan term can increase monthly payments but will reduce the total interest paid and help build equity faster. This strategy is particularly effective if you have the financial flexibility to handle higher payments.
• Maintain the value of your asset : Regular maintenance and timely repairs can help preserve the value of your asset, whether it’s a car or a home. Keeping the asset in good condition can prevent its value from depreciating too quickly, which is important in avoiding negative equity.
• Avoid over-borrowing: When purchasing an asset, ensure that the loan amount does not exceed the asset’s value. A conservative borrowing approach can prevent you from owing more than the asset is worth, thus avoiding negative equity from the start.

Bottom Line

Negative equity can reduce financial flexibility, making it difficult to sell or refinance an asset without a loss. To avoid this, it's important to manage loans carefully. Strategies like making larger down payments, choosing shorter loan terms, and monitoring market conditions can help reduce risks.

Financial Planning Tips

• A financial advisor can work with you to manage your loan debt by reducing interest costs and improving your overall financial health. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now .
• If you plan to buy a home, SmartAsset’s mortgage calculator can help you estimate your monthly mortgage payment with taxes, fees and insurance.

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