What is negative equity and what can you do about it?

What is negative equity and what can you do about it?
What is negative equity and what can you do about it?

While capital growth stories can give us a boost of excitement, negative equity is not a fun topic. A worrying state to be in, negative equity is when you owe more than you own on a property. That is, your equity is tipping on the other end of the scales and if you sell today for its market value, you will walk away not just empty handed but still owing.

It may not be as often talked about, but it can happen. Late last year, for instance, some 7.1 million residences were still facing negative equity in the United States. In December 2011, the number of home owners facing negative equity was sitting at around 6% in Australia, according to RP Data statistics.

How it happens

Negative equity can happen in a number of ways, however the three most simplest explanations are as follows.

  1. A drop in the market

    If you buy at the upper end of the market, and it then drops, you may find yourself in negative equity on your home. This is quite common in faster moving markets, such as mining towns.

  2. You've overpaid in the first place

    Whether you've been convinced into it by unscrupulous marketeers, or you've entered auction overemotionally and under prepared, you may have committed to spending too much. While a bank valuation will usually stop the mortgage from taking place, this isn't always the case.

  3. The asset has been ruined in some way

    Whether it's an uninsured house fire, or damage from some other situation, this can also add to a loss in value.

A combination of the above can spell disaster for any property owner.

What to do if you're in this situation

If you end up facing this, then there are a few things you can do.

  • Check whether it's time to sell: First things first - is the market expected to drop further and soon? If it is, you need to cut your losses and sell as quickly as possible. Don't get yourself in a worse situation by holding on to a failing asset. If it's a $20,000 shortfall then it is better than facing a $50,000 shortfall.

  • Consider renovating: If you have money leftover, consider renovating the property to increase the value. This is not suggested for first time renovators without much concept of adding value, however if you can spend wisely and in visible areas, you may just be able to push the value up to get it over the line for a sale.

  • Move in to the property or weather it out: While not always an option, some facing this situation will see themselves selling their home and moving into the investment property to batten down the hatches and pay down some debt. Similarly, if it's currently tenanted and not too draining, and the market isn't expected to fall further, you may want to batten down the hatches and continue paying it down until you bring yourself into a better situation.

  • Pay it down as best possible: Is there anything you can sell to bring the scales back into your favour? Pour funds into the mortgage to help reduce the amount owing on the property.

How to prevent it in the first place

  1. Put down as much as possible into the property as a deposit. The more money you put into the home in the first place, the bigger the safety net for you. While you will still have lost money, through your deposit being eaten up, you can walk away without the debt at the end. There's a reason lenders have LMI for when borrowers take on high debt levels, and it's not to protect you but themselves.

  2. Keep an eye out for market movements. Be clear on whether there is likely to be an upcoming downturn in your area's property market. Don't act on the basis of panic, but don't be suckered in to the "never sell" mantra if you can act before a downturn.

  3. Buy at a discount. While not always possible, and certainly not easy, having a mortgage for less than the amount the property is worth in the first place can certainly mitigate your risk. Negotiate hard and never overpay.

  4. Try to pay down debt. If you're paying interest only and using your funds elsewhere, ensure it's the best decision you're making. By increasing your equity you're effectively keeping the barrier higher against negative equity.

  5. Buy in lower-risk locations. If you're not prepared to take the downturns with the upturns, then do not buy in higher risk areas.

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Jennifer Duke

Jennifer Duke

Jennifer Duke was a property writer at Property Observer

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