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When applying for a loan to purchase a specific item, such as a house, car or other investment, the item purchased is often used as security for all or part of the loan. In other words, if the borrower defaults on the loan repayments, the lender could potentially take the item purchased as repayment instead.
The equity in the investment is the difference between how much the purchased item is worth and how much is still owing on the loan.
If the amount owing on the loan becomes greater than the value of the investment then the difference between these two figures is known as negative equity. This can happen for a number of reasons, but the most common is due to an unforeseen decline in the asset's value.
In recent years, Australia has enjoyed a surge in house prices, with many Australian cities seeing a drastic rise in house prices. However, this growth could bot be sustained and average property prices hit a peak in late 2003 - early 2004. Following that period many housing markets experienced a rapid drop in house prices, some of 10% or more. Coupled with a rise in interest rates, this has seen many properties enter the negative equity trap.
Case study
To consider an example, William and Chloe bought their first home in 2002. Property prices were booming and didn't look as if they were slowing, so the couple signed on for a 25 year, $450,000 home loan.
Four years later in mid 2006, after a number of interest rate rises had hit the couple hard financially, they considered the option of selling their home. Their idea was that if they moved a little further away from the city, they could still own the four bedroom house they needed but at two thirds of the price of their current home.
William and Chloe were shocked when they had their house valued. The falling property prices had affected their area harder than most, causing a substantial drop in the value of their house. In 2002 they had purchased their dream home for $475,000, by 2006 the value had dropped to $405,000. However, the couple still owed $432,000 on their home loan. William and Chloe now had negative equity in their home of $27,000 and moving was no longer an option.
The danger of negative equity
In William and Chloe's case, they had no choice. To sell their house and purchase a new one they would have needed to find the $27,000 shortfall in their existing home loan in addition to funding the required 5% deposit for their new home. It just couldn't be done.
Most mortgages have this risk attached to them, leaving the borrower open to potential long-term hardship. In general, banks don't bother to monitor the negative-equity situation of individual borrowers, but are interested only in the required repayments being met each month.
No negative equity guarantee
Some loans, in particular the equity access loan (or reverse mortgage), include a no negative equity guarantee. This is a clause written into the contract where, if the value of your property falls below the amount owing on the loan, you will not have to pay back any more than your property is worth.
The no negative equity guarantee does come with certain conditions which vary depending on the lender. These could include keeping the appearance of your property up to a certain standard or even giving the lender the right to decide who can live in your house and if you can have pets there. If the stipulated conditions aren't met, your lender may revoke the guarantee and may even be entitled to evict you.
When taking out a loan it is important that you do your homework, because getting caught in the negative equity trap can end up being one of the most financially damaging situations you will ever find yourself in.