What is negative equity and what can you do about it?

Negative equity is when the amount owed on your home loan is greater than the current market value of the property.

If you fall into negative equity, it can be improved over time as you pay off your mortgage. However, negative equity can become a problem if you need to sell your home.

So let’s unpack the problem – what is negative equity, and what can you do about it?

Put simply, home equity is the market value of a property minus the outstanding balance of the mortgage attached to it.

In other words, with each repayment you make on your mortgage, your home equity increases until eventually you own your property outright.

The amount of equity you have will change over time, as the value of your home goes up (or stays the same) and the amount you owe to your lender goes down.

You can calculate your equity using the following formula:

Market value - outstanding debt = equity ($)

Let’s look at an example:

Nathan takes out a $750,000 loan to purchase an $800,000 home. Two years into the mortgage, Nathan has made $20,000 in repayments, meaning he still owes $730,000. Assuming property prices have not changed, Nathan will have $70,000 in home equity.

Negative equity is when you owe your home loan lender more than your home is currently worth. If you were to sell your home while having negative equity, you would get less than what you originally paid for it, and you would need to pay out of pocket to discharge your mortgage.

This can especially be a problem when a homeowner has to sell because they can no longer afford their mortgage. Not only will their home sale not cover the value of the home loan they’re trying to get rid of, they will owe their lender an outstanding debt and be on the hook for more money they simply don’t have.

Here’s an example of negative equity:

Mary owes $800,000 on a property she had bought for $900,000. But the market nosedives, leaving her home worth just $750,000. In this scenario, Mary’s equity would be negative $50,000.

Assuming the value of Mary’s other assets (such as her car and savings) are less than $50,000, then her net worth will be negative too. That is, she will owe more than the total value of her assets.

Historically, property prices have risen over time in Australia, so most people won’t have to worry about negative equity. This has been suggested by the Reserve Bank of Australia (RBA), which estimated in October 2023 that only around 0.1% of loans in the country are in negative equity.

Still, there are a handful of occasions where the amount you owe your lender can become greater than the current value of your home.

Here are some common scenarios that can cause negative equity:

• You bought at the top of the property cycle and prices have subsequently fallen
• You overpaid for a property and not enough time has passed for home equity to build up
• You bought with a low deposit home loan and the market has dipped slightly
• You have overcapitalised on your property by spending more on renovations than the value it brings

Negative equity is mainly a problem if you plan to put your property on the market. That’s because when you sell a home with a mortgage, the proceeds of the sale are used to pay off your remaining debt.

If the amount you receive from the sale isn’t enough to cover the debt, you’ll have to make up the difference some other way, such as by dipping into your savings or selling other assets.

If you can’t come up with the necessary funds to discharge your mortgage, your lender might be forced to get its mortgage insurer involved. The insurer will pay out the shortfall to your home loan lender before setting out to retrieve the amount you owe, which can be quite a messy process.

Negative equity can also be a problem if you want to refinance your mortgage, which can be particularly frustrating if the home loan interest rate you’re currently paying isn’t all that competitive.

Purchasing a home with a large home loan deposit is a good way to keep your home equity from dipping into negative territory.

Lenders generally recommend a first deposit of at least 20% of the property’s price, as it shows you’re capable of setting aside money regularly and reduces your risk profile in their eyes. Having a larger initial deposit means you are able to take out a smaller home loan and this borrowed portion of the property’s value is known as a loan-to-value ratio (LVR). NOTE

If you can come up with a deposit of 20% or more (some home loans even require 40% deposits), it acts as a buffer in case of any market price falls, because it gives you higher home equity from the very start.

You can also help prevent negative equity by making sure you don’t fall behind on your mortgage repayments. Home equity increases as you pay down your loan, so it’s important to pay both the principal and the interest and only take a repayment holiday if you absolutely need to.

Having negative equity can take a lot of the wind out of your sails, but the problem will usually resolve itself as the market improves and you continue to make repayments on your home loan.

If you want to speed things up, here are a few things you can do to increase your home equity:

• Get ahead by making extra repayments on your home loan
  
• Avoid redrawing from your mortgage
  
• Arrange for an independent property valuation to get a clearer idea of what your home is worth
  
• Consider renovating to increase your home’s value – though ensure you’ll earn a return on investment
  

These can all get you proactive about your home equity, but you can also speak to your lender or mortgage broker and compare home loans to see if you can get a better interest rate.

Did you know your home equity could help you get a lower interest rate?