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The Concept of Negative Equity

Download our example of a negative equity position [ Microsoft Excel .xls file 166KB ]

We'll start off our guidance by defining the concept of negative equity in terms of residential property ownership. The term "negative equity" describes a financial position where the outstanding bond amount exceeds the market value of a residential property. This means that even if the property is sold, the owner will not be able to repay the outstanding amount of the bond. Note that the property market value in this context should be defined as the property selling price less the costs of disposal - in essence therefore the net realisable value of the property.

Property owners who find themselves in a negative equity position are subject to an increased level of financial pressure - should the property need to be sold, the owner will not be able to cover the outstanding bond and will therefore also be left with the obligation of the shortfall. The result could therefore be a financial disaster.

How does negative equity come about?

This is very simple - there is a decline in residential property prices. Recent house price growth statistics reflect single digit nominal growth in property prices. By implication, this means that in some areas property prices have already declined because in some other areas, there is bound to still be growth in house prices. A decline in property prices in some areas is therefore a reality and home owners who purchased properties at the height of the market are left the most vulnerable.

Home loan amortisation - the nature of the beast...

The concept of home loan amortisation is unfortunately frequently misunderstood. The principle is quite simple - if a constant interest rate is assumed, the monthly bond repayment would be constant throughout the entire bond period. The repayment amount consists of interest and capital. The Interest portion is higher at the start of the bond term because the capital that is outstanding is higher and only gradually decreases as the outstanding capital amount is repaid. The capital portion of the monthly bond repayment increases as the interest decreases and the capital portion therefore forms the largest part of the bond repayment amount towards the end of the bond term.

Very simple in theory - but did you know that after a one year repayment period, approximately 98% of the original bond amount is still outstanding? Or that after three years of repayment, 93% is still outstanding? Even worse - after ten years of repayment 67% of the original bond still needs to be repaid! These are estimates that are based on an interest rate of 7% and the figures that are mentioned would look significantly worse at a higher interest rate.

What this means though is that should property prices decline by as little as 2% after a one year period, the home owner who purchased a property at the height of the market would already be in a negative equity position. And we're not even taking selling costs into account. Refer to the home loan amortization page of our website for guidance on how monthly bond repayments are calculated.

Ok, negative equity - now what?

It is very difficult to accurately estimate how long the pressure on residential property prices would persist and to determine the length and impact of a slowdown in the global economy. In principle, a negative equity position only represents a financial crisis if the home owner's cash flow is also under pressure. As long as the home owner is able to service monthly bond repayments, the obligation for the shortfall between the bond amount and the net realisable value of the property does not come into play. The home owner could therefore simply ride out the downturn in the economic cycle until property prices increase and the negative equity position turns into a positive one through a combination of capital growth and the repayment of the bond. It is therefore imperative to monitor expenditure during this time and to ensure that cash flow obligations are budgeted for. Also, if the home owner finds himself in a cash flow crisis, we recommended that an alternative repayment plan is arranged with the appropriate financial institution before defaulting on a bond repayment.

We have included an example of a negative equity position - click the link at the top of the page to download the example file in Microsoft Excel. In this example, the market value of the property declined by 5% over a twelve month period and the property owner now finds himself in a negative equity position because the outstanding bond amount exceeds the net realisable value of the property by R82,548. The example is based on a property with a purchase price of R1 million and a loss of R193,183 has resulted after only 12 months and only a 5% decrease in value! This illustrates clearly why the cat was literally among the pigeons after the sub prime crisis hit the US residential property market and property prices fell by between 15% and 30% in some areas! As you can see, an understanding of the impact of movements in key property variables is a key component in proper personal financial planning.

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