Why should homebuyers beware of negative equity?

Negative Equity exists when at a particular point in time the value of a property is less than the amount outstanding on the mortgage loan used to purchase it. Put simply, the owner of the property owes more to the mortgage lender than the property is worth. Negative Equity arises in two main ways:-

(i) If the property value falls below the amount outstanding on the mortgage
(ii) If the mortgage taken out is higher than the value of the property

For example, if a buyer takes out a 110% mortgage where the additional 10% is used to pay for legal fees, stamp duty, or to purchase furniture etc.

Why should home buyers be concerned about falling into negative equity? This question can be answered by looking at each of these situations in turn.


(i) If the property value falls below the amount outstanding on the mortgage

A buyer purchases an average house in January for £200,000, putting down a 10% deposit (£20,000) and obtaining a 90% mortgage (£180,000). Immediately after the purchase the new owner has £20,000 equity in the property (i.e. the £20,000 deposit they contributed). Over the next few months a shock to the world economy results in a severe contraction of credit. Banks are unwilling to lend money for fear of never seeing it paid back. Businesses begin to collapse as they fail to find the short term funding they require and homebuyers, unable to obtain big enough mortgages, disappear from the market. The evaporation of demand results in a swift but moderate 30% house price crash. The value of an average house is now £140,000.

Can you see what the problem is yet? The house is now worth less than the mortgage used to purchase it and the new owner finds himself in negative equity.


Purchase price of house                              £200,000
Impact of house price crash of 30%               -£60,000
Value of house                                            £140,000
Mortgage                                                   -£180,000
Negative equity                                            -£40,000


This is a BIG problem for the unfortunate homeowners who find themselves in this situation. If you want to sell up, perhaps to move to a bigger house, or to a different area YOU CAN’T! You are simply stuck.

If the owner tries to sell the house, putting it on the market at £140,000 and receives an offer for the full asking price, when it is time for monies to change hands the owner receives £140,000 from the new buyer, and must simultaneously pay the mortgage company £180,000 (the mortgage outstanding). Oh dear! The owner needs to find an additional £40,000 just to repay the mortgage lender. What’s more, the owner has lost the initial £20,000 equity saved as a deposit.

Faced with the need to find an extra £40,000, there are now only two real choices available:

Option 1 – Wait until prices recover
The last house price crash which began in 1989 can be used as a demonstration of what can happen. If you purchased a house at the top of the market in 1989 and fell into negative equity as the market crashed it would have taken 12 years before the real value of your house reached the price you bought it for.

12 years! That’s a long wait! Especially if your family is growing and you need more bedrooms or a proper garden.

Option 2 – Save as much as possible to pay off the negative equity
It probably took many years to save up the original £20,000 deposit. It will take twice as long to save up the £40,000 just to allow you to move out of your current house. Even once this goal is accomplished and you have paid back the mortgage lender, you then have to start over again and save a deposit for the next property you purchase. In all, the average buyer is probably faced with years of conservative spending and diligent saving. Not an enviable state of affairs!

Either way, the end result of the fall in house prices has a dramatic effect on the finances, the lifestyle and the flexibility of the buyer. Consideration must be made of your proposed purchase in light of your future family and financial plans, and in light of the probability of a fall in house prices over the short-medium term.

In today’s market the decision to buy a house at elevated price levels should not be a comfortable one. The risks are substantial. A 30% decrease in house prices is real money that you have lost. A 30% fall on an average £200,000 house is £60,000 that you have actually lost. You must consider whether you would be able to pay back such amounts if the market falls by a range of percentages. Would you be happy to lose that much in savings if you needed to move quickly? But make no mistake, you are the one who is going to have to pay it back to the lender. Every penny.


(ii) If the mortgage taken out is higher than the value of the house

This practice has become more commonplace recently as high house prices and the associated high cost of buying has forced homebuyers to take out mortgages bigger than the value of the house to pay for stamp duty, legal fees, furniture etc. Taking a simple example:


Average house purchased for?               £200,000
Less: Mortgage taken out                    -£220,000 (110% of value of house)
Negative Equity                                   -£20,000 (mortgage debt £20,000 higher than value of house)


Even in this early stage the owner is in potential trouble. Should they need to sell the property the proceeds would not cover the mortgage obligation. For a 25 year repayment mortgage at an interest rate of 6%, it would take around four years to reduce mortgage debt from £220,000 to £200,000, such that it is level with the original value of the house. Four years to emerge from negative equity! Theoretically, the owner would not be able to move out until that time unless they committed more of their own cash to paying off the mortgage.

If house prices corrected by the same 30% as above, the value of the property again falls to £140,000. In this case the owner finds themselves in negative equity so deep and burdensome, that the only attractive alternative is to hand the keys back to the mortgage lender and walk away from the property.


Purchase price of house                         £200,000
Impact of 30% house price crash            -£60,000
Value of house                                       £140,000
Mortgage                                              -£220,000
Negative equity                                      -£80,000


The owner must pay back every penny of the £80,000 owed to the mortgage company, and must then start to save a new deposit for the next property.