What happens if I need to sell my property for less than the mortgage?

Negative equity is the situation where the value of your property falls so far that your remaining mortgage debt is bigger than the property's value. This is a rare situation for most home owners. It goes without saying but selling a property for less than you owe is a financial disaster.

Negative equity explained

Equity is the value of your property minus any debts you have left on the property (like your mortgage).

Let's say you took out a loan of $450,000 to buy a property for $500,000 (so you had a deposit of $50,000). But the market value of the property has since fallen to $400,000. If you still owe $430,000 on your mortgage but you elect to sell the property now, you will still have $30,000 remaining on the mortgage that you will need to pay off.

Negative equity can be caused by a number of factors, including:

• Falling house prices. If you buy when the market is at its high point and median house prices then drop, negative equity is sometimes the result.
• Overpaying for a property. Whether you made an excessive offer to make sure you secured the property or simply got caught up in the excitement of an auction, overpaying is a frequent contributing factor to negative equity,
• Property damage. A property may decline in value if it is damaged or destroyed, for example if a house fire occurs in an uninsured property.
• High loan-to-valuation ratios (LVRs). If you borrow a substantial amount of the purchase price of your property, for example 95%, your home doesn't need to experience a very large decrease in value for you to find yourself facing negative equity.

How to sell a mortgaged house at a loss

If you have negative equity in your home but you need to sell it, you still need to repay the full amount owing on your mortgage.

But before the sale of your property can go through, you will need to obtain approval from your bank. John Costa, Mortgage Choice broker from North Melbourne, says that if you sell your home for less than the balance owing on your mortgage, "the bank will take a number of steps prior to allowing the sale settlement to proceed."

Costa outlines the steps your bank may take:

1. The bank may ask if you can provide any other funds to cover the shortfall, such as any other savings.
2. The bank will also ask you to complete a statement of assets and liabilities. If you have an abundance of assets, you may be required to sell some of those assets to cover the shortfall.
3. Bank transaction statements may also be required to show spending habits. "If there are regular payments for what may be deemed outside normal spending then the bank may seek further explanations from you."
4. If there is still a shortfall, the bank will obtain an independent valuation to satisfy themselves that the property was sold for a fair and reasonable market value.
5. "The bank will want to see that the sale is an "arm's-length" transaction, which means that the sale was conducted by a licensed real estate agent and does not involve a related party sale," Costa says.
6. The bank will submit an application summary to its mortgage insurer seeking approval to allow the sale to proceed.
7. Once the mortgage insurer approves the sale the settlement can proceed and the mortgage insurer will cover the shortfall and pay the bank the remaining amount on the mortgage.
8. The mortgage insurer will then seek to enter into an arrangement to recover the funds from the borrower.

Alternatives to selling at a loss

Negative equity also makes it quite difficult to refinance your loan with a different lender and lock in a better interest rate, so it's important that you take steps to avoid negative equity wherever possible.

Here are some actions you could take before (or instead) of selling.

Avoiding negative equity

You may be able to turn things around or avoid sliding into negative equity by trying the following:

• Make extra repayments. If you make additional repayments towards your loan, you can reduce the size of the debt you owe. A little financial self-discipline can help you avoid the worst effects of negative equity.
• Get an accurate valuation. Before you apply for a home loan, consider getting an independent property assessor to value the property you want to buy to work out whether you are paying too much.
• Avoid borrowing too much. Taking out a loan with an LVR of 90% or higher can be risky. It's much safer to save a large deposit before you start looking for a home loan.
• Refinance or negotiate. If your current mortgage isn't offering a competitive interest rate, consider refinancing with another lender or negotiating a better interest rate with your current lender.
• Ask for help. If you've experienced temporary financial hardship that has caused you to fall behind on your repayments, for example if you were injured and unable to work, approach your bank to see if you can reach some sort of hardship arrangement or repayment holiday to help you get back up to date with repayments.
• Avoid redraws. While redrawing on your mortgage can be convenient, avoiding redraws will help you pay your debt down quicker and avoid negative equity.
• No negative equity guarantee. There are some home loans that feature a "no negative equity guarantee", which limits the outstanding debt on the loan to avoid you falling into negative equity. However, these loans usually come with a range of terms and conditions attached, so make sure to read the fine print closely.
• Consider renovating. In some situations, it may be possible to increase the value of your property by doing renovations to improve the property.

Is it better to keep the property?

It's important to work out whether or not you need to sell the property right now. Is the market expected to fall further in the coming years, resulting in an even bigger gap between the value of your property and the amount you owe on your mortgage? Or might you be better off simply holding onto your property and waiting for the housing market to recover?

If you think property's value is only going to decline further then selling sooner rather than later could prevent bigger losses.

If you're a property investor, riding out a downturn can be easier. Rental income from tenants can help cover mortgage repayments and you can offset losses from your tax. But if you're struggling to find tenants, can only charge a small amount of rent and you're not confident that prices will rise soon enough you might decide to that selling is still better.

Speak to real estate agent

Get a real estate agent's advice on selling the property before you make any decisions. They probably have a better idea of the market than you do. And they might be able to advise you on a strategy.