What Is Negative Equity
Wikipedia defines negative equity as
Negative equity occurs when the value of an asset used to secure a loan is less than the outstanding balance on the loan.
Let’s say you buy your first home. It is worth €50,000 (I could use pounds or dollars or any other currency interchangeably). You put in a deposit of €10,000 which is 20% of the value of the property. The bank lends you €40,000. Your equity is the value of the home minus the value of the loan (€50,000home value – €40,000loan = €10,000equity).
Most people focus on how great it would be if the value of the property increases. Let’s say the property value increases to €60,000 (that’s what somebody would pay if you sold the property). Assuming you hadn’t paid off any of the loan (the loan is still €40,000) then your equity would be (€60,000home value – €40,000loan) €20,000. If you sold your home you would be €10,000 richer than when you started – and the bank would get all their money back.
But perhaps the market corrects a little because you bought in the peak (probably you bought in the peak, that’s when most people feel pressure to buy). Your home goes down from €50,000 to €45,000. When you come to sell you give back the €40,000 you owe to the bank for the loan and you are left with €5,000 (half your deposit). You lost €5,000. That’s harsh but you still had positive equity (€45,000home value – €40,000loan = €5,000equity).
Now the worst case scenario: the market crashes. Your home value goes from €50,000 to €35,000. Your equity now stands at (€35,000home value – €40,000loan) minus €5,000. That’s right, €-5,000. This is negative equity (because the equity is below zero).
What’s So Bad About Negative Equity
You cannot sell when you cannot repay the loan to the bank! It’s that simple. You’re stuck.
Your choices are limited to staying where you are and paying off the mortgage (which might have another 25 years to go). Or you declare bankruptcy.
Well, is this so bad, you think, if you can just continue repaying the loan – at least you have a home! You’re right, it’s not so bad, but you’re denied options.
You cannot sell and move to another town or city where there are higher paying jobs. This may make it nearly impossible to improve your situation in the event that your town has had problems with lower employment and lower property values.
If you had some positive equity you could at least sell (make a loss) and move on. But when you’re in negative equity you simply cannot sell. You either continue paying your mortgage or you declare bankruptcy.
Okay I Can’t Sell, What’s So Bad About That
Your mortgage is probably fixed for 2-5 years. At the end of that fixed rate period your mortgage will go to the floating rate – which, in a bad year, could go anything up to 20%! Just because interest rates have been low in recent years doesn’t mean it can’t go high. The future is unpredictable. You won’t be able to remortgage at a lower, fixed, rate because banks will not lend when you’re in negative equity.
If the value of your home is going down that might indicate other serious problems in the economy. Perhaps the area is less desirable – increased crime. Perhaps there are fewer jobs – and less demand for property. Less demand for rent. So even if you wanted to get a good job somewhere else you wouldn’t be able to rent out your home to cover the costs of renting in your desired town.
You may be okay if the downturn is temporary – in which case just continuing to pay the mortgage payments will get you through that bad time. But do you know it is just a temporary blip and not a more permanent situation?
The Moral Of The Story
Always have as large a deposit as you can when buying a home. Don’t ever think about buying a first home with less than 10% equity (deposit). Try and have 20% equity (deposit). That way – if things do go wrong you hopefully have some time to consider your options while you have them (i.e. sell and move somewhere else).