What is Negative Equity and why is it Bad

As world economies continue their downturn towards full blown recession, we’re starting to see more column inches in newspapers dedicated to the threat to borrowers of negative equity.
Negative equity, though, is not a term that will be immediately understandable to many borrowers, especially younger first time buyers who have not previously experienced a recession. This article, therefore, cuts out the jargon and summarises what negative equity is and what its effects can be.

A dictionary definition of negative equity brings back the following description:

The difference between the value of an asset and the outstanding portion of the loan taken out to pay for the asset, when the latter exceeds the former. Negative equity can result from a decline in the value of an asset after it is purchased. (Source: www.investorwords.com )

Put more simply, however, equity can be defined as the value of your house after your outstanding mortgage amount has been deducted.

Let’s look at a couple of examples to explain the difference between positive equity and negative equity:

Example 1: Positive Equity

You purchased your house for $300,000 and you took out a 100% mortgage to pay for it. That means that your mortgage, on the purchase date was $300,000 also.

It’s six months later and your mortgage has been reduced to $295,000. Your house, though, has gone up in value because demand is still strong to buy property. If you were to sell it now, it would be worth $315,000. Calculating the equity of the property is simple. You just subtract your existing mortgage amount from the estimated current value of the property. In this case that means $315,000 – $295,000 = $20,000.

If you needed to sell the house, you would have $20,000 left (although in reality you’d also have to factor in some additional legal selling fees).

Example 2: Negative Equity

As before, you purchased your house for $300,000 and you took out a 100% mortgage to pay for it. That means that your mortgage, on the purchase date was $300,000 also.

Again, it’s six months later and again you’ve reduced your mortgage to $295,000. However, this time, there has been a slump in house prices, perhaps fuelled by a recession. Your house is now only valued at $270,000. Your equity then is $270,000 – $295,000 = -$25,000.
If you were forced to sell the house, therefore, it wouldn’t cover your mortgage obligation and you’d be faced with a $25,000 deficit to pay off somehow with the bank.

The reason why newspapers and financial websites are focusing on the threat of negative equity is that we have already started to see a fall in the average house prices. In the UK, for example, the BBC has reported that national house prices have fallen by 6% in just the last five months and that much bigger falls may be seen before the trend is reversed (Source: http://news.bbc.co.uk/1/hi/business/7445324.stm )

Negative equity is bad for a number of reasons. Firstly, many of us view a house purchase as part of an investment strategy. We hope that our property’s value will rise substantially in value and maybe we’re thinking of then selling it and putting the surplus funds towards upgrading to a better house.

It can also be a problem for borrowers who are nearing the end of a particular discount deal on their mortgage. They may then wish to remortgage, which is where a borrower switches their mortgage to another mortgage product or provider. However, banks may be unwilling to offer you a deal where the value of your property is actually less than the amount of mortgage that you require.