Who is at risk for negative equity?

No homeowner starts out with negative equity because lenders won't issue a mortgage for more than the home is worth. But negative equity can still happen to anyone with a home loan.

Unfortunately, with more and more homeowners facing foreclosure these days, avoiding negative equity is something every homeowner should consider.

At greatest risk are homeowners with very little equity. Some homeowners may find themselves underwater if home values in their area plummet, or if they experience financial difficulties that prevent them from making their payments on time. (This is exactly what many homeowners faced when the housing market collapsed after the 2008 financial crisis.)

Fortunately, today's conditions make a repeat of 2008 highly unlikely.

"Lenders that lent to homebuyers with low credit scores or to subprime borrowers proliferated because credit was readily available," says Chris Ragland, principal of Ragland Capital.

That is no longer the case.

"Laws passed in 2010 increased scrutiny of borrowers' ability to repay," Ragland says.

How does negative equity arise?

Homebuyers can face negative equity if they have more than one loan on their home and at least one of those loans has an adjustable interest rate.

Negative equity typically occurs when there is a first mortgage and a second mortgage or HELOC," says Jay Garvens, business development manager for Churchill Mortgage in Colorado Springs, Colorado, who has counselled clients on this situation.

"In the current interest rate environment," he explains, "the ability to make monthly payments can exceed a borrower's budget if the first mortgage or any subordinate financing is not fixed rate.

When interest rates spike, homeowners may not be able to make their loan payments. The mortgage balance can increase due to late payments. At some point, the loan balance may exceed the value of the home.

What's wrong with negative equity?

An upside down home loan may mean a homeowner must sell their home to pay off the mortgage.

Garvens recalls that his clients had multiple mortgages, including a variable HELOC with an interest rate that rose from 3.75% to 9.75%.The HELOC increased significantly beyond what they could afford to pay.

"After I provided them with several options, they realised they had to sell the property," says Gavins.

Being forced to sell the property is not ideal, but it's better than defaulting on the loan.

"This makes the danger of foreclosure and credit rating damage very real," adds Gavins. Losing your home to a short sale or foreclosure can ruin your credit for years to come.

Can negative equity be reversed?

Reversing negative equity is possible, though it may be out of reach for the most struggling borrowers. If you are underwater on your loan but still employed, financially stable and not in default, you can do the following:

Continue to make your payments on time and wait for the market to improve until the value of your property increases.

Make an extra mortgage payment each month to help pay down the principal faster.

Consider upgrading your home to increase its value if you have to sell.

If you lose your job or an adjustable rate mortgage causes your monthly payments to increase and you fall behind on your mortgage payments, consider the following:

Rent out your home and use it to pay your mortgage while you live in a less expensive place.

Consider putting your home on the market.

"My first suggestion," says Gavins, "is to sell the home while you still have equity." Use those funds to rent until you can get back on your feet financially."

Renting your home is only a good option if it brings in enough income to cover your mortgage, insurance and other housing expenses.

The best way to avoid negative equity is to make a large down payment when purchasing a home. The larger the down payment, the smaller the monthly payment.

You can also purchase a home well below your budget so that you have extra cash in the bank if you get into a bind. Having a lot of house and little cash is not a good way to deal with financial stress.

A good rule of thumb is to spend no more than 30 per cent of your pre-tax income on housing, and don't forget to add property tax and private mortgage insurance.