Negative equity occurs when the value of an asset used to secure a loan is less than the outstanding balance on the loan. In the United States, assets (particularly real estate, whose loans are mortgages) with negative equity are often referred to as being "underwater", and loans and borrowers with negative equity are said to be "upside down".
In owner-occupied housing market, a fall in the market value of a mortgaged house or condo is the usual cause of negative equity. Negative equity in the owner-occupied market sometimes occurs when the owner obtains second-mortgage home-equity loans, causing the combined loans to exceed the home value. If the borrower defaults, repossession and sale of the property by the lender will not raise enough cash to repay the amount outstanding, and the borrower will both have lost the property and still be in debt.
Negative equity can turn into a curse if something happens unexpectedly that requires that the property be sold. Here is an example.
"I work for a company that is on the decline and decided it was prudent to seek employment in another area. I have accepted a position there but now face a problem. I owe about $20,000 more on my current home than what it can sell for due to declining market values in my area, and I don’t have the assets to make up that difference."
When you sell your house, you must pay off all liens on the house –all mortgages including HELOCs, and any tax or mechanic’s liens. If you don’t retire all existing liens, you can’t convey good title to a buyer, which means you can’t sell.
Negative equity can develop from a decline in local real estate values, as it did in the case of the example above, but that is not the only cause. Home buyers who make no down payment – their loan or loans equal 100% of the purchase price -- have negative equity when they move in. If they had to sell immediately, they could not repay the loans out of the sales proceeds because of the transactions costs. The sales commission alone runs 3-6% of the price.
This is especially troubling when a homeowner defaults or gets behind in their mortgage and needs to sell the property before foreclosure. Then, the only recourse is a short sale.