The Concept of Negative Equity

Firstly, lets define the concept of negative equity in reference to property ownership.

Negative equity describes the financial position when 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. Please also note that the market value should be defined as the selling price less selling costs - in essence therefore the net realizable 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 therefore also be left with the obligation of the shortfall. The result could therefore be financial disaster.

How does negative equity come about?

This is very simple - there is a decline in residential property prices. The latest ABSA house price index reflects an average nominal growth in property prices of only 1% (figures for September 2008). 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 prices.

A decline in property prices in some areas is therefore a reality and the home owner who purchased a property at the height of the market is left the most vulnerable.

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

The concept of home loan amortisation is unfortunately misunderstood commonly. In principle it is quite simple - if a constant interest rate is assumed, the monthly bond repayment would be consistent throughout the bond period.

This repayment amount consists of interest and capital. Interest is higher at the start of the bond term because the capital outstanding is higher and gradually decreases as the capital amount is repaid. Inversely, the capital amount increases and outstanding capital is reduced quicker later in the bond term.

Very simple in theory - but did you know that after a one year repayment period, approximately 99% of the original bond amount is still outstanding? Or that after three years of repayment, 97% is still outstanding? Even worse - after ten years of repayment 82% of the original bond still needs to be repaid! These are estimates based on an interest rate of 15.5% but the effect of capital reduction would be comparable for lower interest rates as well.

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 market prices would already be in a negative equity position. And we're not even taking selling costs into account.

Read more about amortisation here.

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 slow down in the global economy.

In principle, a negative equity position only represents a financial crisis when 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 property net realizable value 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 repayment of the bond.

It is therefore imperative to monitor expenditure during this time and ensure that cash flow obligations are budgeted for. Also, should a cash flow problem occur, it is recommended to discuss alternative payment terms with the financial institution involved before defaulting on a bond repayment.

Understanding the impact of movements in key residential property variables is a key component in proper financial planning.

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