what happens to your equity in a downturn?

[Chi Wen]

So we all know housing will dip/drop at some point. What happens to your equity in situations when you put down 5% vs when you put 20% down?

- Buy a 500k house and put 5% down (25k) and the next day housing prices crash and your house is now worth 400k.
- Buy a 500k house and put 20% down (100k) and the next day housing prices crash and your house is now worth 400k.

in the first case you are "underwater", correct? What does that mean exactly and what kind of real life implication does each case have assuming you keep paying your mortgage and have the same rental cashflow coming in?

[Joe Splitrock]

@Chi Wen this is referred to as a "loss on paper" and it is just an unrealized loss. If you don't sell the asset, you lose nothing. That is why the best strategy is to sell assets when prices are high and hold/buy assets when prices are low. Of course markets don't operate like that. The frenzy that drives prices up means there are more buyers than sellers. The same frenzy drives prices down when there are more sellers than buyers. 

If you are not selling, the main negative of being underwater is that you end up undercapitalized. This is a problem if you are seeking loans, because you are seen as owing more than your assets are worth. If you don't have other cash equivalents or assets, that can mane negative net worth. If/when a housing market turns bad, it becomes very difficult to borrow money, even harder if you have low or negative net worth.

If you are forced to sell when you are underwater, you may be forced to short sale the property. That is when you sell a property for less than you owe. In most states you become personally liable for the difference. In a serious enough situation, you may be forced to file bankruptcy to get out from the debt. This is the worst case scenario.