ANALYSIS: House prices are down around 5% since the end of 2021 and even more than 10% in some areas. While economists aren't expecting further significant falls in value, homeowners who bought near the end of 2021 should start thinking about how they can stay away from going into negative equity.
Negative equity, also known as being "underwater", is when the amount you owe on your mortgage is more than your house could be reasonably expected to fetch at sale time. While this is only a disaster for those needing to sell their house in the near term, it isn't a nice feeling for anyone. It effectively removes the option of being able to sell for that homeowner.
There are two fundamental ways of staying out of negative equity: pay off your mortgage or increase the value of your property (i.e., renovate).
So which is better? Both have pros and cons, and the good news is that both usually have a positive return on investment (ROI). In other words, whether you choose to renovate or pay down your mortgage, for every dollar you put in, you usually get more than a dollar's worth of value out.
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Here is where we get to the first problem with renovating, though. Unlike paying a mortgage down, which always has a positive ROI because you won't pay any future interest on that debt, renovations often have a positive ROI, but not always.
To see what I mean, let's take an extreme example. A house with good bones needs a new coat of paint. To keep it simple, let's say it will cost $20,000, but buyers would, in theory, pay $40,000 more if it looks great. This option keeps you out of negative equity a lot longer than paying down the mortgage by $20,000. In this example, renovating has moved the gap between your mortgage and the value of your home by $40,000.
Mortgage Lab founder Rupert Gough: "Renovations may provide the short-term equity boost needed to stay out of negative equity." Photo / Fiona Goodall
But if you paint the house in horrendous colours, then it's likely that the value of your home may not go up by $40,000 - it may not even go up at all because the next buyer will assume they're going to have to repaint it. And here is the critical point; paying down your mortgage by $20,000 will always reduce the line at which you go into negative equity by that much. Renovations often have a higher return, but it is a gamble. Sometimes the value increase isn't more than the money you put in - landscaping is another example of not always being a dollar-for-dollar benefit.
The second problem is that, to paint your house, you usually need all that money upfront, whereas paying down your mortgage can be done over time. You'll need the $20,000 to paint the house today, whereas you need an extra $400 per week to pay that off your mortgage over the next year.
And finally, there is the problem that renovations deteriorate. Tthe new paint on your house will be tired again in years to come, whereas the reduction in your mortgage always stays the same.
My suggestion, if you are concerned about facing negative equity, is to consider if you are likely to sell in the near future. If so, renovations may provide the short-term equity boost needed to stay out of negative equity. Chat to a friendly real estate agent about what buyers are looking for. These are the things that are most likely to have a good return on investment.
But if you aren't looking to sell any time soon, and staying out of negative equity is your primary motivator, then your order of priorities should probably be to fix things that are causing lasting damage, followed by paying down your mortgage and then looking at renovations last.
In other words, if there is a leaky pipe causing damage to walls in your house, this would be a priority, as the damage it is doing will lead to severe expenses later. Once all those issues are fixed, find out from your bank how you can make extra payments without incurring break fees or penalties. While it's not a quick fix to avoiding negative equity, it is a sure fix.
- Rupert Gough is the founder and CEO of Mortgage Lab and author of The Successful First Home Buyer.
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