Negative equity is a term used to describe a situation in which a person owes more money on their property than it is worth. This means that if a home owner were to sell their property they would not be able to pay off their mortgage with the sale proceeds alone.
Falling into a negative equity situation is, therefore, undesirable. Despite this, many borrowers have virtually invited the problem into their homes by financing their properties with mortgages that have loan-to-value ratios of 100% or more.
If a home buyer secures a 100% LTV mortgage on their property at purchase, then they owe exactly as much as their property is worth at the time of purchase. The home owner will not have any equity in their home, nor will they be in negative equity. This situation could be described as “neutral equity.”
This situation could quickly lead to negative equity if the value of the property declines and the borrower does not pay off any of their mortgage balance. This means that borrowers of 100% mortgages are putting themselves into a risky situation at the outset.
An even more dangerous situation will occur when a borrower secured a mortgage with a loan-to-value ratio of more than 100% on their home. An example of this type of mortgage product is a 125% LTV mortgage. The intention of this type of mortgage is to allow the borrower to purchase the property without funding a deposit, and allowing them an additional 25% loan that can be used for almost any purpose.
Borrowers who secure a 125% LTV mortgage on their home are put into a negative equity situation immediately. The risk associated with using this type of mortgage to buy a home is therefore high.
In all cases, negative equity can arise, or increase, in a declining property market. Borrowers should consider this factor when using high loan-to-value mortgages to buy their properties and ensure that they are paying the lowest price possible. If a buyer can secure a property at a discount below true market value, they can create a hedge against negative equity.
Finally, borrowers who do not have the funds for a deposit in the first place and therefore require a 100% LTV mortgage should carefully consider whether buying a property is right for them. Even a small rise in interest rates can increase the monthly repayments due on a large mortgage balance. Potential home owners may therefore be better off waiting until the have money saved up before jumping onto the property ladder.
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