What is... | January 19, 2011

What is negative equity?

The phrase negative equity is in the headlines, given large drops in house prices in some countries since the financial crisis. So what does it mean? And how can homeowners try to protect themselves?

Negative vibes
Negative equity is when the value of a home falls below the amount of the mortgage debt held against it. The situation is also sometimes called having an underwater mortgage. It can be a relatively common occurrence if house prices have boomed (perhaps leading people to take out large mortgages) and then bust. ING Group chief economist Mark Cliffe ran through some property figures and outlined the dangers of investing in real estate in his second video lesson from the financial crisis.

To sell or not to sell?
As the name implies, negative equity can be an unpleasant situation. Knowing mortgage debt is greater than the value of their home can affect an individual’s financial confidence. If they need to sell, the problem can become more real – moving from a loss on paper to a loss in reality. On the other hand, mortgagees in negative equity who are still able to pay their monthly mortgage may not notice an immediate effect. And if they do not need to sell immediately, it is possible that over time house prices will rise again and the value of the house will again exceed the debt owed on it. But there are no guarantees and in the meantime there may be difficulties getting other loans or refinancing the mortgage with another lender.

What goes up …
History suggests negative equity is not an unusual situation. There have been periods of falling house prices and negative equity in many countries at different times over the decades. The key for homeowners is not to overpay for a property and to avoid buying near the price peak. The eZonomics video Are houses expensive or cheap? says buyers should look at measures such as the ratio between average purchase prices and average wages to try to gauge if homes in an area are overvalued. The higher the number in the ratio, the greater the risk. Also, if buying becomes much more expensive than renting, it can be a sign the market is overvalued.

Insulate against falls
There are practical steps buyers can take to try to avoid ending up in negative equity. Putting a larger deposit down on a house means borrowing less overall and can reduce the risk of negative equity. Buying a more modest property (rather than the most expensive one a budget allows) means buyers can retain some cash as a cushion against future falls. Paying off some of the outstanding debt early will also lower the ratio of the loan to the property value over time. As is often the case with housing, individual circumstances will determine the best course.

InvestingHousingRiskHouse buyingHouse prices

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics