What is negative equity?

What is negative equity?

Negative equity happens when the market value of your property is lower than the balance remaining on your home loan. That means selling your home might not provide enough money to repay your mortgage debt. 

For example, say you purchase a home for $800,000 with a 10% deposit, pay lenders mortgage insurance (LMI), and make interest-only mortgage payments, your mortgage could be about $735,000. If the value of your property then dropped by 10%, it might only be worth $720,000, which is less than your mortgage balance, putting you into negative equity.

Being in negative equity doesn’t necessarily mean you’re in financial trouble. If you can still meet your repayments, you’ll usually continue to pay down your debt, which could help boost you into positive equity, and the housing market has historically evened out over time. 

Though, it could see you in strife if you’re forced to sell the property and may mean you’re ineligible to refinance your home loan.

What causes negative equity?

There are a number of factors that may leave you with negative equity in your property, including:

Buying at the peak of the cycle

Market cycles have periods of growth and contraction. If you buy at the peak, your property may decrease in value for a period of time before you have a chance to pay down some of your home loan debt.

Overpaying for the home

Overpaying for a home is understandable—especially if you become infatuated with the property or you buy in a competitive environment like an auction. If you pay too much for a property, you’ll usually start behind when it comes to potential capital growth.

High loan-to-value ratio (LVR)

Purchasing property with a small deposit can potentially result in negative equity. If you purchase a property with a 95% LVR (a 5% deposit), for example, you’ll usually only have a small buffer of equity against market prices. If the market drops, your loan could be larger in value than your property.

Overcapitalisation

Overcapitalisation can occur when you renovate your property and it ends up costing more than the value it adds. For example, if you increase your home loan by $100,000 to pay for a renovation, but the renovation only adds $20,000 to the value of your home, you’re said to have overcapitalised.

Overcapitalisation can result in you owing more on your home loan than the property is worth.

Are some properties more susceptible to negative equity?

Brand new properties–especially new units–can bring a higher risk of negative equity. There are two common reasons for this:

• Because they may be priced at a premium, with the cost normally including developer and sales agent commissions, and
• because high-density developments can lead to a localised oversupply of a certain type of housing. 

For instance, a new apartment building could see dozens of similar properties hitting the market at a similar time, which means interested buyers could find themselves able to negotiate prices without risking missing out on a property. This can impact property price growth and may result in negative equity, especially for buyers who have bought a new property (perhaps to take advantage of a first home buyer grant) and paid a premium for it.

Similarly, an increase in the supply of a certain type of property, such as townhouses, for example, can cause a lowering of the price for similar new properties. 

Further, properties in areas susceptible to ‘boom-bust cycles’, like mining towns, may present a higher risk of negative equity, as values can fall fast if economic conditions change. 

Why can negative equity be a problem?

Generally speaking, negative equity is only a problem if you need to sell a property, refinance a home loan, or use a property as security for another loan. 

If you need to sell for financial reasons and your loan is larger than the price you receive, you may be left with an outstanding debt.

Likewise, if a property has negative equity, it can be difficult to refinance to a new lender. This is because lenders generally will not take on mortgages larger than the value of the attached property as, if the buyer defaults, the lender might be left in the red. 

How can you get out of negative equity?

If you’re in negative equity, improving your position might be as simple as continuing to make home loan repayments. This could help you pay down the loan until you're in positive territory once more. The property market also moves in cycles and, if prices start to rise again, your property’s value (and therefore your equity) could increase..

Other options that may help reduce negative equity include:

• Considering renovations that add value: Renovating your property may help to improve your equity position, especially if you can do so without taking on more debt. Though, it could be a good idea to speak with a valuer about any work you have planned to determine if it will offer a worthwhile return on investment.
• Making additional mortgage repayments: You may also choose to make extra repayments to pay down your home loan faster. You could also consider making repayments more frequently, such as fortnightly rather than monthly, as this may help you repay your mortgage faster and with less associated interest—improving your equity position.
• Avoiding financial risk taking: If you’re in negative equity, it may be wise to reduce your financial risk taking. Perhaps avoid taking on more debt or investing in highly volatile markets.
• Talking with your lender or mortgage broker: Contact your lender or mortgage broker to see if you can negotiate a better interest rate, thereby reducing your mortgage repayments. 

If you can get a lower interest rate and afford to continue making repayments at the higher amount you were before, you’ll find you can pay off more of the principal in a shorter period of time, increasing your equity as a result. Keep in mind, however, that having negative equity could decrease your bargaining power when asking for a lower interest rate.

Tips to avoid negative equity

One of the most effective ways to avoid negative equity in the future is to ensure you’re not overpaying for a property.

Before purchasing any property, whether established or new, it can be worth understanding its current fair value on the market. This can mean ordering a property valuation or conducting research on recent comparable sales in the local area, as well as planned developments. Major development and infrastructure changes, like if a new highway is planned to run directly past the property or a new hospital or university is being built nearby, are likely to affect its price.

Another way to reduce the likelihood of negative equity is to improve your LVR by having a larger deposit relative to the purchase price.

If you have negative equity in your property, it’s recommended you seek appropriate professional advice. This can help you consider whether you should sell the property, do any of the above options, or hold onto the property until the market improves in the area. 

The most important thing is not to panic. Speaking with a financial counsellor or adviser may help you determine the best strategy for your circumstances.