When you take out a secured loan, you put up an item of value (called the collateral) against the loan.
With a mortgage this is the house you are buying. If you don’t make payments on the loan, the lender can repossess and sell the collateral to get their money back. The term equity refers to the money you would receive if the collateral were sold and the loan paid off. If your house were worth £250,000and you had a mortgage of £100,000 you would have equity of £150,000.
But what happens if the collateral doesn’t cover your loan? In this case, you would still owe the lender the balance of your loan. If this happened on your mortgage, you would: end up losing your home, have to pay rent, and still make payments to the mortgage lender!
Negative equity is when the value of the equity (or collateral) is less than the outstanding balance of your loan.
Negative equity can have severe impact on your finances for a long period of time.
How would this happen?
The two most common times this happens are on mortgages and car finances.
Houses in the UK have tended to increase in value. The ONS graph below shows the change in average house prices in the UK.
But from the graph you can see 2 periods where house prices have dropped and taken time to recover.
1. September 1989 when it took until March 1997 for prices to rebound.
2. September 2007, when it took until August 2014 for prices to rebound.
If you had bought a house prior to these house price reductions, once prices dropped, the sale value of your house might not have covered your loan.
The second common situation where you might find this happening is car financing. Cars go down in value from the moment you drive them off the forecourt. If your car drops quicker than expected, you might find that your car is worth less than your loan. Common causes of this are:
· Driving more miles than the average driver.
· Damaging the car.
· Shift in buyers demands affecting second-hand prices e.g. shift from estate cars to SUV’s.
· Recession affecting second-hand car sales.
LTV ratio and negative equity.
The lower the LTV ratio, the more equity you have. This means that prices must drop further for you to end up in negative equity. Check out our blog on Why loan to value ratio’s matter to find out more.
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