The return of negative equity

As the papers turn bearish on the housing market, the phrase 'negative equity' is being used for the first time since the 1990s. But who is most at risk, and what are the consequences?

The papers are full of doom and gloom about the housing market and the property sections are suddenly starting to include the dreaded phrase "negative equity" for the first time since the early 1990s. But what is "negative equity" and why is it such a problem?

In short, if your house is currently worth less than your outstanding mortgage balance then you are in negative equity. Say you bought a house for £250,000 six months ago using a 100% "interest-only" mortgage, so your repayments only cover the mortgage interest each month rather than reducing the original loan. If today the market value of the house has dropped to £245,000 then you are in negative equity to the tune of £5,000 (the property is worth £5,000 less than the loan that finances it).

By contrast, if you bought a £250,000 home today but only took out, say, an 80% mortgage, then the value of the property would have to drop below £200,000 (the loan being 80% of £250,000) before you would fall into negative equity.

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So, the people who are most exposed as property prices fall are those who took full advantage of the 100%+ mortgage deals that were becoming commonplace up until last summer's credit crunch a 120% mortgage on a £100,000 property created immediate negative equity of £20,000 even had prices stood still, let alone fallen. Trouble is also brewing for anyone who has been decreasing the equity in their home, by remortgaging or second-mortgaging.

A recent report from credit-ratings agency Experian illustrates just how widespread the problem may be by looking at the relationship between mortgage and house values for the UK. At highest risk are homeowners in major cities, such as Manchester and Glasgow, where sky-high prices compared with wages have forced many buyers to overstretch themselves. Indeed, the UK's number one negative equity hotspot is Sighthill in Glasgow, where the average house carries a mortgage of 94.53% of its value. It would therefore only take a 5.48% drop in price to plunge a typical owner into negative equity.

Nationally, Experian estimates that 8,000 homeowners are already in negative equity and should property prices fall by just 10% that figure becomes 23,000. However, they see prices falling much further, which would trap more than 70,000 homeowners. Given that Halifax announced that house prices fell by 2.5% in March alone, meaning the average price of £191,556 is almost £5,000 lower than it was a month earlier, their gloomy forecasts have every chance of becoming a reality.

So what are the consequences? In short, owing your bank or building society more than your house is worth makes it nigh on impossible to move since you are unlikely to be lent any more money for a bigger home and you may not even be able to transfer your existing loan from one home to another.

Negative equity also creates a headache for those seeking to remortgage. Last year, according to the Council of Mortgage Lenders, nearly 90% of new UK mortgages were taken out on fixed-rate terms and when those terms end, as 2.5 million will over the next 18 months says the CML, the trouble begins. Those in negative equity won't be able to simply shop around for a new deal since all the 100%+ deals will have long-since disappeared. This means they will be automatically transferred onto standard variable rates, which at an average of around 7.5% just now are guaranteed to create big "mortgage payment shocks". And for those who suddenly can't fund their new repayments, repossession beckons the CML expects a 50% rise this year.

The best way to avoid all this is to prioritise paying down the mortgage, if you are already on a repayment deal. For those on interest-only, consider switching repayment terms. With property values crumbling, one of the best investments you can make is getting rid of debt.

Ruth Jackson-Kirby

Ruth Jackson-Kirby is a freelance personal finance journalist with 17 years’ experience, writing about everything from savings and credit cards to pensions, property and pet insurance. 

Ruth started her career at MoneyWeek after graduating with an MA from the University of St Andrews, and she continues to contribute regular articles to our personal finance section. After leaving MoneyWeek she went on to become deputy editor of Moneywise before becoming a freelance journalist.

Ruth writes regularly for national publications including The Sunday Times, The Times, The Mail on Sunday and Good Housekeeping among many other titles both online and offline.