Negative equity
For any homeowner with a mortgage, being in a negative equity situation can be problematic. However, negative equity is a term commonly misunderstood by homeowners and need not always be a cause for concern.
Let’s first define the concept of equity and negative equity, before we explain how and why it occurs, and how you can check whether you are currently in a negative equity situation. With this understood, please refer to the bottom of the page for practical advice on the possible options available to you if you find yourself in this situation.
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What is equity?
To understand the concept of negative equity, it is best to first understand the meaning of ‘equity’ in relation to property and your home. In summary, your equity is how much of your home you actually ‘own’. This is denominated either as a percentage (%) or an absolute amount (£). The value is dependent on two facts:
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the deposit that you paid initially for your home; and
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the amount of your mortgage balance you have paid off so far
To translate this into numbers, if you purchased your home for £100,000 with a £15,000 deposit, at the time of purchase you would have had a 15% equity in the property. Your mortgage would have stood at £85,000. If you paid off a further £35,000 of your mortgage, your total ‘equity’ share would be £50,000, or 50%.
However, if your home was to fall in value at any time, this could result in your equity in your home becoming ‘negative’.
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What is negative equity?
Negative equity is a situation whereby the current value of your property is less than what you have left to pay on your outstanding mortgage. This is primarily a problem if you want to sell your home, because you may not recover the full amount of your outstanding mortgage when you sell.
Taking the example above, if you purchased your home for £100,000 with a £85,000 mortgage, but the house is now worth £75,000, you would be in negative equity. This is because your mortgage value is £10,000 more than your property value (calculated as £75,000 house price minus £85,000 mortgage value = -£10,000).
However, not all house price drops automatically result in negative equity. Returning to the example above, if the property you bought for £100,000 on a £85,000 mortgage was now valued at £95,000, you would still be in positive equity (£10,000) as the existing value (£95,000) is greater than your mortgage (£85,000). Similarly, not all negative equity situations are a cause for concern. If you are not seeking to or in need of selling your home immediately, and can continue meeting your mortgage payments for the foreseeable future, you can temporarily avoid the impact of negative equity.
Why and how does negative equity occur?
Similar to many other assets or items, a property or home’s value fluctuates over time, often for reasons outside of your direct control. The primary reason for the occurrence of negative equity therefore is falling house prices.
Prices in any market, be it property, motor vehicles, jewellery or any other item of value, are determined by the amount of supply and demand in that market. Our useful links section sets out further detail if you like to learn more about the economics of how prices are set in any market.
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Why do house prices fall?
Prices in any market, such as the property market, fall due to one of two reasons.
Firstly, if demand for property decreases. Buying a home is the largest financial purchase we make during our lifetimes, and house prices and the state of the UK economy are intrinsically linked. It is easier to secure mortgage financing when the economy is healthy, growing and the future prospects for the country are positive. During these times interest rates are typically lower, as the Bank of England sets a lower ‘base rate’ of interest which ultimately drives the interest rate lenders offer you when you take out your mortgage.
Furthermore, during these periods lenders relax their mortgage lending criteria, for example by allowing you to buy properties with lower deposits. This makes it easier for people to buy property, therefore house prices increase. Conversely, when the economic outlook is more pessimistic, borrowing becomes harder and tougher, mortgage approval levels fall and this results in fewer people able to buy property. This decrease in buyers reduces competition in the market and causes property prices to fall.
Secondly, if the supply of property increases. When the times are good and the UK economy is buoyant, unemployment is low and people have money to spend, this typically also means homeowners are meeting their mortgage payments. However, when the economy is facing hardship, many people struggle financially. The primary reason for this is unemployment, whereby businesses face difficulty results in many people losing their jobs.
The impact of mental health and stress can also not be underestimated during these times. Many battle with depression or large periods of mental strain, resulting in separation from their partners, divorce and health problems. A combination of these factors ultimately results in one key outcome; the increase of properties on the market, either through repossession, separation or divorce, or due to those that have unfortunately passed away. More available properties to buy, together with fewer buyers as mentioned above, result in an uncompetitive market in which there are more properties than anyone is able to buy. This results in a fall in property prices.
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What is a recession and how does it impact property prices?
A recession is a period of time during which economic activity declines. In the UK this period is defined as ‘two consecutive quarters’, therefore six months in a row. Most recognised markets follow a ‘boom and bust’ cycle, where activity is strong for a period and then stagnates or declines for a period. Property is unfortunately no different!
When the economy is in ‘trouble’, it impacts a number of the sub-markets within it, such as property, car buying, retail, leisure, transportation and so on. Keeping our focus on the property market, when confidence in the economy is strong and there are lots of buyers on the market, prices surge and a ‘property bubble’ can form. Unfortunately, similar to any other sector nothing is guaranteed, therefore the bubble will eventually ‘burst’ or ‘crash’. A result of this is that many homeowners may have overpaid for what their property is truly worth during this ‘bubble’, ending up with a substantial mortgage and property prices that are set to fall.
Negative equity was a big issue in the aftermath of the 2008 recession, which saw house prices plummet. In their wake, thousands of homeowners were in negative equity as their mortgages were much higher than the value of their home.
This recession was directly driven by the demand and supply reasons referred to above. Banks became over-confident with the continued rise of property prices and did not expect the increases to stop. As a result, getting a mortgage became easier for homeowners, with banks accepting more and more high-risk mortgages. People who would not normally meet the affordability criteria for mortgages were able to buy with up to 100% mortgages, meaning they started off with minimal initial equity and large repayments. When this ‘house of cards’ approach to lending came falling down, many defaulted on their payments and lost their homes, increasing the supply of property. At the same time, lenders almost entirely stopped mortgage lending (you may remember it often being referred to as the ‘credit crunch’) reducing the demand for houses. This caused property prices to head into freefall, resulting in the house price ‘crash’.
In summary, a recession almost always will result in property prices to fall. However, the amount of the fall will depend on the severity of the recession.
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How can I check whether I have negative equity?
If you are concerned that you may have negative equity, you can easily calculate your loan-to-value (LTV) ratio by taking the following steps:
Step 1: Contact your lender to find out how much you owe on your mortgage. You may already have this on a recent mortgage statement.
Step 2: Get an understanding of the current value of your property. You can do this by getting local estate agents or surveyors to value your home (this may incur a fee). If houses have sold close to you recently, you may be able to use this as a proxy.
Step 3: Subtract the amount you owe on your mortgage from the value of your home. If the number is negative, you are in negative equity.
Worked example to assist you in your calculation. Replace your figures with those below to check whether you are in negative equity.
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Property purchase price: £100,000
Owned so far through deposit and mortgage payments made: £15,000
Outstanding mortgage amount: £85,000
Current property value: £75,000
Equity: -£10,000 (Current property value – Outstanding mortgage amount)
Loan to value: 113% (Outstanding mortgage amount / Current property value)
If your LTV ratio is greater than 100% it means you are in a negative equity position. If you think you might be in negative equity but are unsure and would like us to check or advise, please feel free to get in touch.
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Should I worry about negative equity?
Not necessarily. Similar to many other areas of life, we can be influenced by the media and others to fear the concept of something without fully understanding it. Whether or not you should be concerned by negative equity is ultimately dependent on your personal situation.
If you are not seeking to or in need of selling your home immediately, and can continue meeting your mortgage payments for the foreseeable future, you need not be concerned about negative equity at this time. However, there are a few situations where negative equity can be problematic.
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Looking to sell your home: this can be a difficult situation to navigate because if the sale value is likely to be less than the outstanding mortgage amount, you will face a shortfall to your mortgage lender when you sell. If you do not have alternative assets or means to pay off the debt shortfall, or cannot agree a practical payment timeline with your lender, you may end up facing bankruptcy.
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Facing mortgage arrears: similar to the above, if you need to sell your home to clear your mortgage arrears, negative equity can add to the financial burden and debt that will be due to your lender after the sale.
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Facing repossession: under a repossession scenario your mortgage lender will have or be seeking to have the ability to sell your home. This will likely be at a substantial discount to the current market value of your home and incur higher fees compared to if you sold on your own terms. Combined with negative equity you may find yourself with an uncontrollable debt burden if you are unable to prevent your lender selling your home.
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Looking to remortgage: it is unlikely your lender, or an alternative lender, will agree to a fixed rate or cheaper deal if you are in negative equity. This may sound counterintuitive, but the best mortgage deals are reserved for those with the highest amounts of equity in their home, typically 40% or greater. You will find that your monthly mortgage costs are either comparatively higher, or will increase when the term agreed with your lender expires. Most initial mortgage ‘deal’ terms in the UK are between 2-5 years.
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Do you have any advice for dealing with negative equity?
The most simple piece of advice if you are not impacted by any of the issues above is – stay put! Whilst it might sound strange but negative equity is essentially a house ‘trap’ whereby you have lost the flexibility to move home, unless you are prepared to meet your shortfall debt to your lender through your savings or the sale of other assets. In this scenario it is best to almost ‘do nothing’ and continue making your mortgage payments, if you intend on living in your home for the foreseeable future and have no intentions to move.
If you are not necessarily in a rush to move but wish to proactively manage your negative equity, there are mitigating actions you can take:
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Wait for prices to rise: if you have just recently bought your home (within the last three years for example) you may be in negative equity due to the small amount of mortgage you have paid off up to this point. This means that your equity is likely to largely consist of your deposit which is typically 10-20% of the house value. If you are in a position to be patient, it might be best to sell your property when house values have increased as the selling price will also be higher, helping to lift you out of negative equity. You will also have the benefit of increased equity due to the repayments made during this intervening period.
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Take action to increase value: if you are under time pressure, you can look to increase the value of your property to increase your chances of securing a price that does not leave you in negative equity. You could renovate key areas of your property that add value, such as the bathroom or kitchen, or potentially expanding your property with an extension. While this means spending money, the increase in the value of your home may be greater than the amount spent, enabling you to command a higher selling price and avoid negative equity. Before undertaking this exercise you could always speak to an estate agent or look at comparable property prices nearby that have similar enhancements to seek what potential price you might be able to command.
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Increase equity: if you are not cash constrained and your finances permit, you could increase the equity you have in your property by overpaying your mortgage with one off cash contributions (early repayments). This will reduce the amount you owe and can help reduce or remove negative equity altogether. Lenders typically charge a fee if you overpay past a certain limit, therefore check your mortgage agreement or contact your lender to confirm before you make any overpayments.
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Rent out your property: subject to your lenders consent, you could rent out your existing property and instead live in a rented property in a cheaper area. Whilst this might not appear ideal, it will allow you to gain additional income to put towards additional mortgage overpayments, which in turn will reduce the amount of your negative equity. The greater the difference between the amount you receive as income from the rental of your property and the amount you pay in rent for the house you rent to live in, the more effective this option will be.
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Switch to interest only: if you are cash constrained but in a position to be patient and do not need to move, another option would be to switch your mortgage payments to interest only for a period whilst you wait for prices to rise. This may seem counterintuitive but by reducing the amount you have to pay on your mortgage, you can service the interest for longer and avoid having mortgage arrears or being repossessed, thereby keeping your head above water long enough for you to let the market recover.
Please feel free to speak to us if you are affected by any of the above and feel you might benefit from some free, impartial advice. Equally, we would be more than happy to discuss ways in which we might be able to help and the options which may be most beneficial for you.
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