How To Cope With Negative Equity

What can you do to protect yourself from a 1990s-style negative equity crisis?

This article was first sent to Fools as part of our 'The Good, The Bad and The Ugly' email series. 

Thanks to the credit crunch house prices are now falling. That could mean a return to a 1990s-style negative equity crisis. What can you do to protect yourself?

Negative equity means the outstanding mortgage on your home is higher than the value of the home. In other words, if you fall into negative equity, you'll owe your mortgage lender more than your home is actually worth.

Why is negative equity bad?

Negative equity becomes a problem when you want to sell your home or remortgage.

Selling your home

If you're in negative equity, moving up the property ladder to a larger home will be extremely difficult. That's because you don't have any equity in your current home to put down as a deposit on your next property.

Remortgaging

If you're coming to the end of your mortgage deal, it usually -- but not always -- make sense to remortgage so that you avoid your lender's standard variable rate (SVR). The SVR is normally the lender's highest mortgage rate.

But negative equity means it could be very difficult to find a willing lender. The credit crunch has led to the disappearance of 100% and 100% plus mortgages. That means you may be forced onto your lender's SVR with no option to go elsewhere.

Even if you manage to escape the negative equity trap and build up equity of say, 5% or 10%, you may still find your options on remortgaging are severely restricted as lending criteria tighten even more.

Should you be worried about negative equity?

That really depends on whether house prices continue to fall and by how much. When you bought your home, and how much you had to borrow also affects the risk of negative equity. If you bought your home several years ago, house prices will still be higher now than they were back then, so the risk of negative equity is lower.

If you had a large deposit initially, or you have plenty of equity, house prices will have to drop significantly before negative equity becomes a problem.

The group who are most at risk are those borrowers who bought recently at the top of the market with little or no deposit. On top of that, if they took out an interest-only mortgage without an investment plan to repay the capital, the threat is even greater because the mortgage debt stays the same.

That said, it's worth remembering that if house prices fell by 10%, around one in 75 houses face negative equity, according to research by the Financial Times. So most Fools probably won't be affected unless house prices really start to tumble.

What can you do to protect yourself from negative equity?

• Firstly, reduce your mortgage debt as quickly as you can. If you can afford it, many mortgages will allow you to overpay by up to 10% a year without any penalties.
• If you get a bonus or other windfall, consider using it to pay off a chunk of your mortgage. Alternatively, if you want to sell up, you could use the cash for say, a new kitchen or bathroom, which could add value to your home and help to ward off negative equity. Read this article for more ideas.
• If you want to sell, think about simple home improvements, such as decorating and tidying up your garden, which could increase its value.
• If you have a spare room, rent it to a lodger and use the income to tackle your mortgage debt. Under the Rent-a-Room scheme you can earn up to 4,250 tax-free a year.
• If you think you may have difficulty remortgaging after your deal comes to an end, start saving the extra amount you might have to pay in a high-interest savings account or a tax-free cash ISA. This will help you prepare for payment shock should your repayments rise significantly. Find out how much you would have to pay on the SVR and save an equivalent amount. This will build up a reserve to overpay your mortgage if needed.
• If you have an interest-only mortgage but no investment plan to repay the capital, think about switching to a repayment mortgage if you can. That way you can start tackling your mortgage debt now.
• If your finances won't stretch to overpayments or saving, try boosting your income. A second job is an obvious option. Think of it as a temporary solution until your situation improves.
• Most importantly, if you think you're going to struggle, contact your lender ASAP. Lenders generally want to avoid repossessing your home, so you may find they're more accommodating than you thought.

On a final note, I don't want to spark mass panic. According to Halifax, house prices are currently 3.7% lower now than they were a year ago. They'll have to fall a lot further before negative equity becomes a widespread phenomenon.

If you need to remortgage, speak to a broker at The Motley Fool's award-winning Mortgage Service.