If you have negative equity after five years, it means that the value of your home is less than the value of the outstanding debt on it five years after you buy it. If you were to sell your home at that moment, you would lose money.
Most people buy homes hoping that the price will rise, increasing their wealth over time. However, that doesn’t always happen. In some parts of Wales, prices are actually falling, leading, in some cases, to “negative equity.”
Negative equity is a serious financial issue both personally and for the economy as a whole. If negative equity persists for a long time, then people are less likely to pay back what they owe, destabilising the financial system, as happened during the Financial Crisis.
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Is negative equity after five years a risk?
If you make regular monthly mortgage payments on time for five years, then the risk of falling into negative equity is low. Even if house prices fall slightly, you still have time to build a sizeable equity cushion in your property, making it worth keeping.
The risk of negative equity rises; the more the market crashes, the higher the loan-to-value ratio.
In 2008, for instance, property prices fell more than 15 per cent from their high, crashing from £188,657 to £159,340. Buyers on 90 or 95 per cent mortgages saw their equity wiped out and wound up owing banks more than their property was worth.
Certain circumstances increase your risk of going into negative equity. These include:
Taking out an interest-only mortgage. Interest-only mortgages deny you the ability to build equity. You never pay back the principle, so you never increase your share of ownership in your home. Therefore, your equity cushion never grows, making you more vulnerable to negative equity if prices fall.
Buying your property during the market peak. Buying a home at the wrong time, such as in the height of the 2008 property boom, also makes it more likely your home will fall into negative equity.
Having a 95% or 100% mortgage. These mortgages have very little to no equity cushion at all, meaning that any price increase could put you into negative equity territory.
Something damaging your property. Natural disasters, subsidence and even vandalism can all reduce the value of your property to the point where it falls below the amount you borrowed to pay for it.
What are Help To Buy Equity Loans, and why might they result in negative equity after 5 years?
Getting a Help To Buy equity loan lets you buy a property with a smaller deposit.
The government-backed scheme lends you up to 20 per cent of the value of a new-build home for the first five years, interest-free, covering the deposit most mortgage lenders charge. The aim of the scheme is to help people get onto the property ladder, increasing home ownership.
For instance, suppose you want to buy a home for £200,000 in Cardiff. Under a conventional 75% loan-to-value mortgage product, you would have to stump up £50,000 to cover the deposit. The lender would then give you the remaining £150,000 to hand over to the seller when you move house.
However, with the government’s Help to Buy Scheme, you could buy the house with just a 5 percent deposit. In this scenario, you would pay £10,000 towards the deposit, and the government would provide the remaining £40,000 – 20 percent of the property’s value.
To qualify, you must be a first-time buyer and live in a new build home below the Welsh price cap of £250,000. You must also apply before 31 October 2022 so that you can purchase the home you want before the scheme officially closes on 31st March 2023.
Unfortunately, no matter how good the interest rate is on your commercial mortgage deal, those on the Help to Buy scheme is much more likely to run into negative equity.
The reason for this has to do with the structure of the scheme. For the first five years, you do not pay any interest. However, once the initial grace period is over, you must pay 1.75 per cent on any amount outstanding, with fees increasing with the RPI plus 1 per cent every year. With increasing repayment costs, it becomes hard to pay off your mortgage and the loan.
The government recommends that people save up to pay off their equity loans during the first five years. However, the amount that you have to pay back is based on the property valuation at the five-year stage, not what you bought it for, which could go up. Buyers must also pay valuation fees, cutting into the ability to pay back.
On the Help to Buy scheme, even a small fall in the value of your property can lead to negative equity because those on the scheme frequently borrow 95 percent or more of the value of their home. House prices need only fall by 5 percent to see 5 percent mortgage equity wiped out.
With that said, it’s not all doom and gloom. Because the amount you owe on Help to Buy fluctuates as a percentage value of your property, you will end up owing less if house prices fall. For instance, if property prices fall 25 percent, the government equity loan value of 20 percent on a £200,000 property would fall from £40,000 to £30,000.
Should you pay off the equity loan or mortgage first?
Financial advisers are split on whether people should pay off their equity loans or mortgages first after saving a lump sum during Help to Buy’s initial five-year interest-free period.
If you can pay off the home equity loan, you can avoid interest payments in the future, potentially saving you money long-term. However, if you pay off the mortgage, you can own a larger chunk of your property.
Beware of increasing your monthly mortgage repayment. You could wind up with early repayment charges. For further property advice, get in touch with Mark King Properties today.