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What is negative equity and how you can avoid it

In a period of massive growth in house prices, many Australian homeowners are sitting on an asset – or assets – that continue to pay dividends. But what happens when prices go rapidly in the other direction?

With the recent housing bubble predicted to burst at any time, on top of rising interest rates, negative equity is a real possibility for many Australians when house prices go south – especially for those who have bought at the peak of a price-rise cycle.

Negative equity is a term that means your home or an asset that you have significant borrowings against is worth less than the value of the mortgage. Put simply, if you sold your house you would still owe the bank money on it.

Equity is the percentage of the asset that you own. If you have 15 per cent equity, you own 15 per cent of the asset. If you have zero equity then you don’t own any of the assets.

 

How to avoid negative equity

If your house falls in value, it doesn’t automatically mean you’re in negative equity. It only happens if the value of your property falls below the outstanding balance of the mortgage.

Avoid the peak

To avoid negative equity, avoid buying a home at the peak of a cycle, such as right now. When prices peak, they eventually come down and if you’ve paid $1.5 million for a house that is suddenly worth $1.1 million you’re already behind.

When prices peak, buyers – especially first home buyers – tend to get desperate to get into the market and will overpay for a property. This compounds negative equity when prices fall.

 

Save a bigger deposit

If you are buying a house, having a larger deposit can also help prevent negative equity if prices fall.

Saving that little bit extra – such as a 15 per cent deposit rather than 5 per cent – can insulate you against falling into negative equity.

 

Be smart on renovations

Overcapitalisation can also be a common issue that pushes homeowners into negative equity.

This occurs when homeowners refinance to pay for renovations that exceed the actual growth in value for the home.

For example, if you borrow a further $150,000 from the bank to pay for renovations that only raise the value of the house by $120,000, then you are in negative equity.

Pay more on your mortgage each week

Overpaying your mortgage, if you can afford it, also helps avoid negative equity.

 

Do your research

Other tips to avoid it include doing your research on the property and the neighbourhood. If a significant development is slated for the neighbourhood, such as a loud or unsightly warehouse or highway, then the value of the property could be affected.

Also, get all the appropriate inspections and valuations done before you buy and you will avoid any unexpected and costly issues that could creep up later on.

Brand new properties are also a risk, especially those in large complexes. These are subject to developer costs and commissions and are usually targeted by investors as a source of rental income only due to their tendency to not go up as highly in value during cycles.

Properties close to utilities and transport hubs – such as railway tracks or stations – are also subject to oversupply and are primarily targeted as rental-income properties. Therefore, they don’t increase in value as much as other properties during spikes, and can fall further in dips.

 

Article from: au.finance.yahoo.com