Negative Equity

Q: What is negative equity and how does it happen?

Negative equity arises when the outstanding loan on an asset, like a house, is greater than the asset’s current market value. This typically occurs if the value of the asset drops, often due to changes in the property market or economic downturns.

Q: How can I calculate if I am in negative equity?

Subtract the current market value of your property from the outstanding loan. If your loan balance is £205,000 and your property is valued at £190,000, you have £15,000 of negative equity.

Q: Can negative equity affect refinancing options?

Yes, negative equity can restrict your ability to refinance. Lenders generally require a loan amount below the asset’s value, so borrowers in negative equity may not qualify for new loans or better rates until equity improves.

Q: Is negative equity only relevant to property?

No, negative equity can occur with any secured loan, including car loans or business assets. For example, vehicles deteriorate in value quickly, so car owners can find themselves owing more than the car is worth early in the loan term.

Q: What options are available for those in negative equity?

Options include making regular repayments until the equity position improves, waiting for asset values to recover, or discussing alternative arrangements with your lender. In severe cases, government programmes or special refinancing solutions may be available.

Finance Dictionary >Negative Equity

Negative equity occurs when the outstanding balance on a loan, typically a mortgage, exceeds the current market value of the asset securing it. For example, if a home is worth £180,000 but the mortgage is £200,000, this results in negative equity of £20,000. An interesting fact is that thousands of homeowners experienced negative equity after the 2008 financial crisis when property values fell sharply and did not recover for years. Negative equity is important as it can prevent selling or refinancing property and can increase financial vulnerability for borrowers.

What is Negative Equity?

Negative equity is a financial situation that arises when an asset's market value is less than the amount owed on the loan secured against it. This scenario most often affects homeowners but can also impact vehicle loans and business assets. For instance, consider a homeowner who bought a house for £220,000 with a 90% mortgage (£198,000). If a downturn hits the property market and the value drops to £180,000, but the mortgage balance after some repayments is £195,000, the owner is in negative equity by £15,000. This means the borrower owes the lender more than the home can be sold for, creating challenges in moving or refinancing.

Real-world example: During the late 2000s in the UK, many homeowners who bought at the height of the property market bubble found themselves in negative equity when after the property value corrections, their homes were worth significantly less than their mortgages. This scenario made moving house, remortgaging, or selling extremely challenging without incurring substantial personal losses.

How Does Negative Equity Occur?

Negative equity can develop in several ways. The most common is a decline in asset value, usually due to market fluctuations or corrections. If you buy a property with a small deposit and property prices drop, you quickly enter negative equity. High loan-to-value mortgages, interest-only loans, or borrowing against depreciating assets can also increase risk. For example, new cars lose value rapidly after purchase, so car owners with small down payments can find themselves in negative equity within months.

Calculating Negative Equity: A Step-by-Step Example

To determine negative equity, subtract the market value of the asset from the outstanding loan balance. For example, if a mortgage on a property stands at £210,000 and the current valuation is £185,000, negative equity is £25,000.

Formula:

Negative Equity = Loan Balance - Asset Market Value

Calculation:

Suppose Ms. Smith purchased her home for £250,000 with a £225,000 mortgage. After five years, she has paid down her mortgage to £215,000, but property values have dropped, and her home is now worth £185,000.

Negative Equity = £215,000 (loan) - £185,000 (value) = £30,000

This £30,000 indicates how much more Ms. Smith owes compared to the asset’s value. The result directly influences her options if she wants to sell or remortgage.

Negative Equity in the Property Market

Negative equity is most often discussed in relation to the property market, particularly during periods of economic downturn. Homeowners with high equity have built up a buffer against market changes, but those with high loan-to-value ratios are vulnerable if prices fall. The consequences of negative equity in real estate can be severe, sometimes leading to homeowners being "trapped" in their homes because selling would not cover the outstanding mortgage. In severe cases, repossession can occur, resulting in losses for both borrower and lenders.

Implications and Options for Borrowers

Being in negative equity can limit financial options. Homeowners may find it difficult or impossible to refinance at better interest rates, as lenders are concerned about the low security coverage. Standard sales become challenging because the selling price may not cover the outstanding debt, which often means the borrower must find alternative funds to cover the shortfall. Sometimes, borrowers in negative equity may seek special arrangements, such as business loan refinancing or government support programmes, especially if wider economic factors are involved.

Pros and Cons of Negative Equity

Negative equity offers little benefit, but its presence often highlights risks and lessons regarding borrowing and market fluctuations. On the downside, individuals in negative equity have restricted financial flexibility, face challenges in selling or refinancing assets, and risk repossession or bankruptcy if they cannot keep up with payments. In rare cases, lenders may offer new deals or government schemes may emerge to help affected borrowers, but these are the exception. The experience can encourage more cautious borrowing or better understanding of market risks but is largely regarded as disadvantageous.

Historical Perspective and Recovery

The concept of negative equity became widely recognised during significant economic downturns, such as the UK housing crash in the late 1980s and the global financial crisis of 2008. During these times, rapid falls in property or asset values left many borrowers vulnerable. Recovery from negative equity depends on a combination of regular loan repayments, market recovery, or, where possible, injecting additional capital to pay down the loan. Some homeowners wait out market downturns until property values rise again, thereby restoring a positive equity position.

Key Considerations and Avoiding Negative Equity

To avoid negative equity, borrowers should aim for sizable down payments, conservative borrowing, and consideration of the likelihood of market fluctuations. Understanding the risk of depreciation, particularly when buying with high leverage, is crucial. Consulting financial professionals and choosing the right mortgage structure or considering products such as discount mortgage may help minimize risk. For businesses, negative equity in company assets can signal financial distress and may impact credit ratings or the ability to secure further funding.

For those navigating the implications of negative equity, finding the right support and exploring financial solutions is key. If you are concerned about how negative equity affects your options or need guidance in finding a way forward, you may wish to learn more about the business funding solutions available to support your financial goals and recovery.