Negative equity is a term used in buying property that means that the value of the property is worth less than what is owed on it.

The purpose of investing in property is the hope that the value will rise over time. As the value of your property grows, so does your equity in that property – that is, the share of the property that you own.  However, like with any investment, there can be no guarantee that your property will grow in value. If house prices drop, there’s a chance that it could be worth less than what you owe.

To calculate the equity in your house is a straightforward calculation: the current value of your property minus what you have left to pay on the loan – essentially, this is the original price paid minus the initial deposit and repayments.  Crucially, if the figure is below zero, the property is then in negative equity. Equity can increase under two circumstances. Firstly, by the property growing in value, the loan is reduced in proportion to the percentage of the property’s value. Secondly, as repayments are made each month on the mortgage, the share of the property you own will increase.

Since house prices do fluctuate, there’s no need to be overly concerned if prices drop a little in your area. If the drop isn’t larger than what you have paid in deposit and repayments, you won’t be in negative equity. With a market crash like the one we witnessed in 2008, where the market saw a drop of 15% in just one year, this can be a harsh loss on the equity of homer owners.

House prices in England have seen a steady rise in value since 2009 in the wake of the financial crash. In fact, prices grew by a staggering £25,000 average over the year to November 2021. 

Risk from declining house price

In the situation where house prices do start to fall, whether nationally or locally, there are certain circumstances which will heighten the risk of finding yourself in negative equity.

If you have only just bought a house, for example, you won’t have made many repayments, so the deposit will only be the equity that you have. Of course, the lower the deposit, the lower the equity.

With a 95% or 100% mortgage loan, the only equity you have comes from monthly repayments and any capital growth. This highlights the potential risks with such mortgages with little or no deposit. It can leave you more vulnerable to negative equity in a declining market.

Negative equity can also result from overpaying for the property. Furthermore, if the property was bought in a “red hot market,” right at the peak, any downturn or crash could result in you owing more than you have paid.  

Another potential risk comes from buying the property with an interest-only loan, something that is common with buy-to-let investors wanting to receive rental income without having to use the money to pay back the capital until the end of the loan term. Here, capital growth is how equity is built. If the value of property goes up over the 25-year mortgage term, the final capital repayment will only be the original sum, while the property could now be worth substantially more. In the meantime, the investor has raked in many years’ worth of rental income which can be used for purchasing further properties.

Negative equity risk can also be found if the property was bought in a location that is subject to a long-term economic or property market slowdown. Therefore, as part of the due diligence process, the location should be given careful consideration and data collected on things like job prospects or proposed infrastructure projects.

Finally, something could happen to the property itself, causing it to lose its value.

What is the effect of negative equity?

You could find yourself in a precarious situation if you end up in a negative equity situation.

If you were looking to sell your property, for whatever reason, you would end up owing money to the mortgage lender after selling it because the sale price wouldn’t cover what was owed.

It’s not uncommon for home buyers to think about remortgaging their home to move away from harsh interest rates and find a better deal, after the initial fixed term has ended. However, your mortgage lender will unlikely agree to a deal in a situation where the home would not be sufficient to act as security. Consequently, you may find that you are not able to move away from the lender’s variable interest rate and are therefore stuck having to pay more for your mortgage repayments.

Not all may be lost, however, if you find yourself in a negative equity situation. Your credit score, which is important if looking for deals down the line, doesn’t have to be negatively impacted, under certain conditions. It will only negatively affect you if you have moved house and can’t make up the difference, or if you default on your mortgage repayments. Therefore, if you can remain in the property and carry on with the repayments every month, you may not be affected by the negative equity.

If you find yourself in a negative equity situation, the options open to you depend on your circumstances and your future.

Staying in the property and keeping up with payments, if possible, is a good option to consider. This would enable you to continue building up your equity share in the property.  

If your circumstances allow for it, and indeed, so do the conditions of your mortgage, you can consider making overpayments to bring down the loan more quickly. This can be a beneficial strategy because mortgage rates are typically higher than savings interest.