What Is Negative Equity?
With the economies of the world continuing to battle their way out of one of the worst recessions in living memory and pay off monumental debt figures, the media is full of stories analysing how well the recovery is going.
One thing we do know for certain - the population of the world is growing and that means ever-rising demand for housing.
It's a classic demand and supply situation - strong demand and lack of supply pushes prices up. But, at what point will the peak be reached, where the price of houses becomes too high to meet demand? And how can we be sure we aren't heading back into a recession?
For a home owner, the lack of supply and strong demand are great, but for those looking to buy for the first time it's tricky - property is expensive and you need to time it. If you buy with a mortgage at the top of a house price boom and a recession hits, the value of your house is likely to drop. And that means you could fall into the trap of negative equity. This article explains, in simple terms, what negative equity is and how it is worked out.
Negative equity - the official definition
Negative equity is a term used to refer to a situation where the outstanding balance of a secured loan exceeds the value of the property that the loan was taken out on. Negative equity often occurs when a homeowner purchases a property with a mortgage and then the demand for property drops (often as a result of a slowing economy), resulting in a subsequent fall in house prices.
How is negative equity calculated?
The calculation of negative equity can done by taking the value of the asset at the current time and deducting the outstanding balance of the mortgage loan.
A person holding negative equity is said to be "upside down" or "under water."
I find that the best way to teach things is by giving an example. So, let's say you take out an interest-only mortgage on a property at $200,000 over 20 years. A couple of years after buying it, the economy starts to slow and house prices drop. When you get your house valued by a real estate agent, they tell you that the property is now worth $150,000. What does this mean for you?
- Value of your outstanding loan: $200,000
- Value of the property: $150,000
- Negative equity: $50,000
Now, in the case of the above, you still have the remaining mortgage time left for the property value to rise. It only, therefore, becomes a problem if you want to move (meaning you would have to take a lower offer and pay back the extra $50,000 to the bank or carry it over).
Negative equity and assets
Although negative equity usually occurs because of fluctuations in an asset's value and price, it can also occur with a fixed asset. As an example, if your loan payments are less than the interest charged each month, the loan balance will increase. This situation is referred to as negative amortization.
Written by Alastair Hazell
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Last update: 21 October 2015
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