Negative Equity: Why Most Homeowners Can Rest Easy

For most people who buy a home, a mortgage represents the single largest debt they will take on in their lives. But what happens if the market value of a property you've bought falls below the amount you still owe on your home loan?

This situation is called "negative equity". In Australia, decades of house price growth have meant it simply hasn't been a pressing national issue. Now, as house prices fall across large parts of the country, could it soon become one?

Speaking after the Reserve Bank's decision to leave interest rates on hold last Tuesday, RBA Governor Michele Bullock said less than 1% of Australian households were in negative equity.

Bullock also said that, according to RBA modelling, even if house prices fell by 20%, only about 5% of households would end up in this situation.

That could still amount to tens of thousands of people, including many recent home buyers with large outstanding loan balances.

However, being in negative equity may not be as much of a problem as some recent headlines might have you believe. Here's why.

Prices are sliding from lofty heights

This year's three interest rate hikes and tax changes in the May federal budget are continuing to cool the property market.

Property data firm Cotality's home value index for July shows quarterly falls of 3.4% in Melbourne and 4% in Sydney, with national prices down about 2%. Across combined regional areas, prices were down 0.1% over the quarter.

Commonwealth Bank, Australia's largest mortgage lender, last week announced home loan applications were down 15% since the federal budget in May.

It's a similar story at other banks, with investors in particular pulling back from the market.

This suggests a period of weaker demand caused by tax changes, rate rises and general market uncertainty will put downward pressure on prices. How long this will last is anyone's guess.

Who's most affected? And who's protected?

Assume a first home buyer bought a small house in outer Sydney for A$1 million in July this year, borrowing $950,000 under the government's 5% deposit scheme .

Let's say over the next two years, this person pays off $24,000 of the outstanding mortgage (not including interest). But over the same period, the market value of the house falls by 10%, to $900,000.

If they suddenly needed to sell, the sale proceeds alone would not cover the $926,000 left on the mortgage. This household would be liable to the bank for that $26,000 shortfall. That household is therefore in negative equity and they would also have lost the $50,000 of their equity used as the deposit not to mention the costs of buying and selling.

Using a larger deposit - say 20% - may have shielded this buyer from going into negative equity on paper. While this buyer would still have lost money overall if forced to sell at short notice, they wouldn't still owe the bank money.

For households with loan-to-value ratios above 80%, banks typically require lenders mortgage insurance. But this insurance protects the lender, not the borrower, from negative equity.

If there is a $26,000 shortfall on the mortgage, the insurer will compensate the bank and then pursue the homeowner for repayment.

What newer home owners need to know

Those most affected by negative equity are newer owners who bought at or near the peak of the market, and are then forced to sell by a change in circumstances, such as sudden unemployment or a family breakup.

Being forced out of your home and still being liable for repayments on the equity gap is a horrible, but thankfully rare, situation.

For others who don't need to sell immediately, the effects are more muted. One of the biggest impacts of being in negative equity concerns household mobility - you are tied to a particular dwelling and unable to move for a new job. It is also more difficult to refinance.

There is also a " wealth effect ", with households less likely to spend when in negative equity and when house prices are falling .

The long game

Given the average holding period for dwellings is between eight and ten years , there would need to be a sustained and sharp downturn to affect a significant number of households, particularly those that purchased before 2025.

While tax changes may have shifted the dial on demand slightly, there is still an imbalance between demand for housing and the limited supply we have available. This is likely to result in future, albeit hopefully more sustainable, price growth.

Significant interest rate rises, lending restrictions and a weak economy leading to sharp increases in unemployment are the factors most likely to deliver sustained price falls. These are looking unlikely in the short term with economic forecasters such as Deloitte forecasting continued economic growth .

The longest sustained national downturn in recent history was between October 2017 and June 2019. Here, though, the fall between peak and trough was just 8.5%.

It is worth noting that local markets differ significantly. In Perth, for example, prices fell slowly between 2014 and 2019, down around 17.5% from peak to trough but have since more than doubled.

But big, sudden market crashes are unlikely because of the balance between demand and supply. Markets tend to bounce back quickly following a downturn, as purchasers who have played a waiting game jump back in.

For those households worried about negative equity who have bought a dwelling as a home rather than a financial asset, it is a case of sit tight, pay down that mortgage and wait it out.

Steven Rowley receives funding from the Australian Housing and Urban Research Institute and the Australian Research Council.