Negative equity explained

Negative equity occurs when your property is worth less than the home loan you took out to buy it. This typically occurs because the value of your property decreased or the size of your home loan has increased – or both.

Your home equity is the difference between your property’s value and the remaining balance of your home loan. For example, if your property was worth $500,000 and you still owed $250,000 on your home loan, you’d have $250,000 in positive equity.

But if you owed $480,000 on that same home loan and your property’s value dipped to $460,000 due to market fluctuations, you’d have $20,000 in negative equity. So, if you sold your house for $460,000, you’d still owe your lender $20,000 after using the full sale amount to cover the outstanding balance on your home loan.

You can easily determine if you have negative equity or not by comparing the value of your home against the outstanding balance of your home loan. If you owe more than your property is currently worth, you have negative equity in your property.

Negative equity can be caused by different factors, including:

• Overpaying for a property when you purchased it
• A decline in your property’s market valuation due to market fluctuations
• An economic recession or depression that causes a widespread decline in property prices
• Overcapitalisation (i.e. funding renovations using your existing equity via refinancing and spending more on them than you’ve added to your property’s value).

Other factors that won’t result in negative equity but could increase your risk of falling into negative equity include taking out a home loan with a small (e.g. 5%) deposit, or knowingly making an inflated offer on a property to compete with other would-be buyers.

Having negative equity in your property isn’t ideal but can be dealt with in the medium to long term. It’s only an issue if you want to sell or refinance in the short term.

For example, negative equity could happen because of a sharp market downturn at the start of your loan term. It’s not an ideal situation, but the property market will likely bounce back at some point, and your equity will go back from negative to positive if property values rise and you make regular home loan repayments.

However, if you try to sell a property that you have negative equity in and it sells for its current value (or less), not only would you owe your lender the entirety of the sale amount, but the balance of your negative equity as well.

If you want to refinance your home loan while you’re in negative equity, you’ll typically be out of luck entirely, as lenders won’t let you borrow more than what they assess your property as being worth.

If you’re in negative equity and want to refinance your home loan, you’ll need to pay off your negative equity first, and get yourself to a point where you have enough positive equity to borrow against – 20% is generally a good minimum to aim for.

The good news is that being in negative equity has no immediate effect on your financial situation. It won’t change the size of your home loan repayments regardless of whether you’re on a fixed or variable rate home loan, and it doesn’t come with any fees or costs.

As mentioned, negative equity only becomes a problem if you want to sell your property or refinance your home loan. If you don’t plan on doing either of those things, you’ve got the rest of your home loan term to pay your way back to positive equity.

Yes, being in negative equity affects your borrowing power as it’s usually impossible to borrow or refinance against your property until you’re back into positive equity.

Generally speaking, if you’re in negative equity you should shift your focus from borrowing to paying down your home loan and working your way back into a position of positive equity.

As your credit score is largely determined by your repayment history and the number of credit applications you’ve made recently, having negative equity typically won’t affect your credit score. Keep making your regular home loan repayments and you’ll be contributing to growing both your credit score and your positive equity.

There are a few ways you could potentially get out of a negative equity position and into a position of positive equity. They include:

• Continuing to make your regular mortgage repayments and reducing the size of your home loan relative to the value of the property.
• Making additional repayments towards your home loan to accelerate the process of reducing your home loan balance relative to the value of your property.
• If you were pushed into negative equity by a downturn in the property market, you may be brought back into positive equity by a future uptick in property values.
• Explore ways you could potentially increase the value of your property without increasing the size of your debt – landscaping, a fresh coat of paint, or any renovations you can do cheaply could all add value to your property.

Anything you can do to shrink the size of your home loan and/or grow the value of your property will help you work towards positive equity.

If you need to sell a property while you’re in a negative equity position, you will need to pay off the balance of that negative equity to your lender after the sale to close your home loan.

This means you’ll be on the hook for the difference between the sale price and how much you owe your lender and will be required to pay that difference out of pocket.

While you can’t protect yourself entirely against falling into negative equity, there are some steps you can take to reduce the risk of negative equity happening to you. They include:

• Making sure you have the largest saved deposit possible before taking out a home loan to buy a property.
• Paying attention to property market cycles and trends so you know when to buy and not buy or seeking professional advice from a financial advisor.
• Avoid the temptation to pay too much for a house just because you want it.
• Be thoughtful with any planned renovations so you add more to your property’s value than you’re spending on the work.