NEGATIVE EQUITY: Definition & How It Works With Mortgages

The amount of equity you have in your home can have a significant impact on your future finances and capacity to climb up the property ladder. In layman’s terms, equity is how much of a home you actually possess, mortgage-free. It is calculated as the difference between the overall worth of your house and the amount you still owe on your mortgage. This page is intended for anyone who wants to learn more about negative equity. You could be a homeowner who is paying off a mortgage or a first-time buyer who wants to understand negative equity before applying for a mortgage. Learn more about what to do if you are a current mortgage customer with negative equity.

What is Negative Equity?

Negative equity occurs when you owe more on your outstanding mortgage than you could raise by selling your home. When house values decline, it can have an impact on borrowers who only have a small amount of equity in their homes.

Understanding Negative Equity

To understand negative equity, we must first understand “positive equity,” or, as it is more popularly known, home equity. If a mortgage is used to purchase some or all of a home, the lending institution has an interest in the home until the debt obligation is met. Home equity is the portion of a home’s present value that the owner owns outright.

Home equity can be built up through either a down payment paid at the time of purchase or through mortgage payments, with a portion of each payment designated to pay down the remaining principal. Property owners might benefit from rising property values because they raise their equity value. When the opposite occurs—when the current market value of a home goes below the amount owed on the mortgage—the property owner is labelled as underwater.

Having a home with negative equity The seller incurs a liability if they sell a home with negative equity since they are obligated to their lending institution for the difference between the associated mortgage and the sale of the home.

The Economic Implications of Negative Equity

When a homeowner obtains a mortgage prior to the collapse of a housing bubble, a recession, or a depression—anything that causes real estate values to fall—this might result in negative equity. Assume a buyer financed the purchase of a $400,000 home with a $350,000 mortgage. If the market value of the home falls to $275,000 the following year, the owner has negative equity in the home since the mortgage tied to it is $75,000 higher than what it would sell for in the current market. If the outstanding monetary amount on the mortgage is greater than the home’s value, the property, the mortgage, and the homeowner are said to be underwater.

Underwater mortgages were a prevalent issue among homeowners during the height of the financial crisis in 2007–2008, which included, among other things, a significant deflation in housing prices. As the following outbreak of the Great Recession showed, a broad epidemic of negative equity in the housing market can have far-reaching consequences for the economy as a whole. Due to the possible losses from the sale of their properties, homeowners with negative equity found it more difficult to aggressively seek work in other locations or states.

Particular Considerations

Negative equity is not to be confused with mortgage equity withdrawal (MEW), which is the removal of equity from the value of a home through the use of a loan against the property’s market value. A mortgage equity withdrawal reduces the real worth of a property by the number of additional liabilities against it, but it does not indicate the owner is now in the red in terms of equity.

What should I do if I have Negative Equity?

If you’ve gone into negative equity, the options accessible to you will be determined by your unique circumstances and what you expect to do in the next few years.

If you’re able to stay in the house and make your payments

In this case, your best bet may be to keep making payments, which will gradually increase the amount of equity you have. You might also consider making extra payments if your mortgage agreement permits it, which would help you pay off your loan faster. Mortgage interest rates are typically higher than savings interest rates, so you may be better off putting some cash into your mortgage loan.

Prices may begin to climb again in the long run, helping to reduce or even reverse the level of negative equity. It may also be feasible to increase the value of your home by upgrading or adding features that are in demand in your neighbourhood. However, this is a high-risk strategy because you may end up spending more on renovations than you gain in value. In most circumstances, your money would be better spent paying down the loan.

If your mortgage contract is about to end

When your mortgage arrangement expires, it’s common sense to consider remortgaging; however, lenders may refuse to provide you with a new deal if you’re already in negative equity. This means you’ll be transferred to the lender’s standard variable rate (SVR), which will normally be higher, raising your repayments. As your arrangement comes to an end, ensure that you will be able to meet the new SVR payments in the long run.

If you have to relocate

If at all possible, avoid selling your house while it is in negative equity, if you are forced to sell for less than the loan amount, you will be liable for making up the difference.

However, your mortgage lender may allow you to repay the amount over time through a payment plan, so it’s worth contacting them before selling.

Remember that selling when in negative equity means you won’t earn a profit and will lose the deposit you paid, which means you might not be able to buy a new home right away.

Only a few specialist lenders offer ‘negative equity mortgages,’ which allow you to transfer the negative equity to a new property instead of repaying the debt. However, you may incur early repayment penalties on your existing mortgage, and interest rates are typically very high.

If you need to relocate, another alternative is to rent out your property. However, you will be responsible for making repayments while the house is vacant, as well as paying rent in your new location, which may put you in a worse financial situation.

If you are unable to make your payments

If you’re having trouble making your mortgage payments, call your lender right away. They may provide choices to make your repayments more affordable. Meanwhile, continue to pay what you can. Don’t be tempted to just stop making payments; mortgage arrears will leave a blemish on your credit report and may prohibit you from purchasing a house in the future.

In the worst-case scenario, your home may be repossessed by the lender. Your home will then be sold as rapidly as possible, frequently for less than the market value, leaving you owing the bank more than if you had sold it yourself.

How can I avoid falling into a Negative Equity situation?

If you are concerned about negative equity, you can take the following steps:

When making a purchase

• Do your homework to ensure you’re paying a fair market price for a property.
• If the market is really ‘hot,’ that is, prices are at an all-time high, consider waiting a year or two until activity calms.
• Put down as much money as you’re able.
• Even if the instalments are appealingly low, avoid interest-only arrangements.

When you own

• Overpaying your mortgage may be an option if your contract allows it.
• Remortgage when your current agreement ends to ensure that you are always paying the highest rate.

The Benefits and Drawbacks of Negative Equity Mortgages

Pros:

You can move without having to pay off your mortgage’s negative equity. This is especially handy if you need to relocate for career or family reasons and can’t put it off any longer.

Cons:

• You may be required to pay early repayment penalties on your existing mortgage.
• There may be additional fees and penalties, and your new mortgage may have a higher interest rate than your current one.
• They are available from only a few lenders.

Help to Buy and Negative Equity

The government lends you 20% of the purchase price of the house (40 percent in London) in exchange for a stake in the property via the Help to Buy equity loan scheme. The financing is interest-free for the first five years.

You must make a 5% down payment and then obtain a mortgage for the remaining 75% of the property’s value (or 55 percent in London).

When you buy with a tiny deposit, even a small drop in house prices can drastically destroy the equity you have.

However, if you go into negative equity with a Help to Buy loan, you may be marginally better off than if you had a 95% mortgage.

This is because the government owns a percentage of your property rather than a fixed monetary sum. This implies that if the value of your home falls from £200,000 to £150,000, the amount you’d owe on a 20% Help to Buy equity loan will fall from £40,000 to £30,000.

Negative Equity and Guarantor Mortgages

Many first-time buyers are turning to guarantors or family mortgages as they struggle to get on the housing ladder. These types of transactions allow a family member to pledge their house or cash savings as collateral, and the buyer to take out a 100% loan. You’re more likely to fall into negative equity if you don’t put down a deposit, especially in the early years of your mortgage before you’ve made considerable repayments.

If you are forced to sell while in negative equity, or if your home is repossessed, a family member will be held responsible for making up the difference, which could cost them their own home. As a result, you should be cautious to ensure that you can meet your repayments and that you are unlikely to be forced to sell for less than the asking price.

Negative Equity and Buy-to-let

Capital growth increases the allure of buy-to-let because it gives the investor long-term income while the asset itself increases in value. As a result, many investors use interest-only loans, which means they just pay the interest and not the principal on the property. In principle, the rent collected each month pays off the interest, while capital growth raises the investor’s stake in the equity.

If the home value does not rise, your part of the equity will not rise, limiting your ability to remortgage or pay off the loan. You also won’t have any equity in the property to use to fund your next acquisition and build your portfolio, which is a frequent technique. However, rents do not always correlate with capital growth, so you may be able to continue renting out the property and repaying the interest until the market recovers.

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