For many First Time Buyers, the size of the mortgage they’re taking out to buy a home is a lot larger than the deposit they’re putting in. This is called LTV (loan to value) and until you’ve paid off your mortgage for a significant number of years (or have put more money towards it) your lender owns more of your home than you do.
This isn’t a problem if you don’t intend to move. But what if you need to sell sooner than expected? That’s where negative equity comes in.
What is negative equity?
Negative equity is when house prices fall and your outstanding mortgage loan is larger than the current value of your property.
For example, you buy a house for £300,000 with a £30,000 deposit (10%). You therefore owe £270,000 to the mortgage lender. Let’s say you pay back £700 per month plus interest. In 12 month’s time, you’ll have paid back £8,400.
But then house prices fall by 15%. You’ve paid back £8,400 in mortgage repayments over 12 months, which means you still owe the mortgage lender £261,600 plus interest. But due to the fall in house prices your property is now only worth £255,000. This is negative equity.
Is negative equity a problem?
Owning a property is a long-term investment and house prices are constantly fluctuating. As long as you’re able to keep up with your mortgage payments, negative equity doesn’t really matter – it only becomes an issue if you want to sell or remortgage the property.
In the example above, if you needed to sell the property you’d get around £255,000 for it. But once it was sold you’d need to pay back your mortgage lender, which could be problem because there’s a £6,600 gap between what you owe the lender and what you’ll get for your property.
If you want to remortgage the property (for example, because your fixed rate mortgage is coming to an end) the story will be similar. You won’t be able to borrow more than the property is worth, so you’ll need to find that extra £6,600 elsewhere in order to pay back your original mortgage lender.
How can I avoid negative equity?
Buying a house is an investment, and all investments come with an element of risk. You’ll never be able to completely eliminate the danger of negative equity, but there are things you can do to minimise the impact.
Before you buy
Have a bigger deposit
The less you owe the lower the risk of falling in negative equity. Let’s take our example again.
If you buy your £300,000 property with a 10% deposit, the 15% drop in house prices later will mean you owe the lender £270,000 but will only get £261,000 from the sale of the property.
But if you bought the property with a 20% deposit, you’ll only owe the lender £240,000. The £261,000 from the sale will comfortably cover this.
As a result, if you’re able to wait a little longer before buying your first home, then it’s worth saving up a bit extra to put down a larger deposit. In a recession properties don’t usually drop in value by more than 20%, so if you’re able to save up at least 20% then do.
Buy below market value
This might not always be easy, but sometimes opportunities arise to put in an offer lower than the market value. For example, do you know that the seller is looking for a quick sale? If so they might be prepared to take a lower offer just to get the transaction completed. And remember, as a First Time Buyer you are an appealing option for a seller because you will be chain-free. It’s always worth giving it a go!
Also, if you get a survey and the report reveals problems, this could be an opportunity to negotiate a lower price. But just make sure that the repairs needed aren’t more than you can deal with or afford.
Get quotes for surveys.
If you already own your home
Pay more off your mortgage
The less you owe to the mortgage lender, the lower the risk of finding yourself in negative equity. So, if you’ve got a little bit extra each month, it might be worth putting it towards paying off a bit more of your mortgage.
Be aware of how much you can overpay by before your mortgage lender charges you. For most this is 10% of the outstanding balance every year, but it’s best to check to avoid extra costs. Not only will this reduce the risk of negative equity but it will also reduce the interest you need to pay.
Increase the value of your home
If your property’s value has fallen, or you’re worried it’s going to, there are things you can do to counteract this.
Some easy ways of adding value to your property include:
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Decorating: it might not add thousands, but sellers can be put off by your choice of décor, so repainting in neutral colours can add value
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Improving kerb appeal: for example, repoint the brickwork or repaint the doors and window frames
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Do up the garden: even if you can’t afford to redesign it, small tweaks like trimming vegetation and sweeping up leaves can have an impact
There are also bigger things you can do, like remodelling or adding an extension.
However, be aware of the ‘ceiling value’ of a property – this is the maximum a property is likely to sell for, largely dependent on location. You don’t want to put loads of money in property improvements but not have your time and investment reflected in the resell value. An estate agent will be able to give you an estimate for the ceiling value of your property.
Read more about how to add value to your home.
Mitigate being forced to sell
Property prices falling is not a problem if you’re not currently planning on selling. But if something happens that means you have to sell your home quickly, you might be forced to sell while you’re in negative equity.
There are a number of things you can do to ensure you’re able to wait for prices to rise again before selling, which mainly give you a financial buffer should your situation suddenly change. For example:
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Insure against things like job loss and getting ill
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Make sure you’ve got sufficient savings to tide you over for at least a few months if you lost your job
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If you own the property with your partner, come up with a plan for what happens if you split while the property market is bad – for example, will you get a lodger, or rent out the whole house?
Bear in mind that if something major happens to the property market it can take several years to recover. So do what you can to ensure your plans are sustainable, both from a financial and personal point of view.
The most important thing is to not assume property prices will always go up. Your property, if buying with a mortgage, is not necessarily an investment – it's a loan you’re repaying. Buyers seem to assume that they will make a profit on their first property, but that may not be the case. Many people moving on from their first home had to put more money in for their next deposit. So it’s always worth continuing to save, even when you’ve bought your first home.
Try not to worry about negative equity too much – by nature house prices fluctuate constantly. By following our advice you can minimise the chance of being impacted by negative equity and be safe in the knowledge you’ve done everything you can. For information about what’s going to happen to house prices in the next three months, check out our House Price Forecast.