Negative equity is the concept that occurs when the value of an asset falls below the amount of debt on the asset. In this article, we shall discuss –
- Positive Equity
- Negative Equity
- Implications of Negative Equity
- Illustrations of Negative Equity
Whenever an investor purchases an asset (let’s say a house), the investor may end up taking some loan and putting in some capital of his own (also known as the down payment).
Cost of house (Asset, 100%) = Down payment (DP, 20%) + Bank Loan (BL, 80%)
In this case, the individual has put in some money, and the financial institution has provided some capital. When compared with each DP and BL, assets will be bigger. This situation is called positive equity.
Also, when you start using your asset, if the asset price increases despite you using it, it is called positive equity. This is relevant in the case of a property as generally; property prices tend to go up.
Thus, the asset price will be more than the loan in the asset at any point. This is the scenario of positive equity.
Moving on to the negative equity bit, Negative equity is when assets fall below the amount borrowed to acquire the asset.
Now when will this situation come?
The negative equity comes into the picture whenever the asset depreciates upon being used. For example – you buy a car, use it for two years and then sell it. It may sell at a price lesser than the loan amount, thus resulting in negative equity for the borrower.
The implication of negative equity
Following are some scenarios and its implication –
1. Negative equity for an asset
Negative equity for the asset is generally seen in the case of automobiles that are financed through debt. The automobile goes through wear and tear, and the value tends to reduce as you use it more. Similarly, it may also happen when the value of the car is the same, but you have not made enough payment to your outstanding debt, and due to the interest component, your loan is higher than the value of the automobile.
2. Negative net worth
The situation typically is seen in individuals and is likely to arise when the assets owned by the individual is lesser than the liabilities owed. A typical example where it is commonly seen is a student with a student loan. While student loans are for acquiring education, they are intangible and don’t account for any physical asset. Thus, during student loans, the individual has a negative net worth.
3. Negative equity in a financial asset such as share
For companies, negative equity happens when the liabilities are higher than assets. In general, the balance sheet is depicted by –
Assets – Liabilities = Shareholder’s equity + Retained Earnings
The equity goes negative in the following scenarios –
a) Accumulated Losses
When a company has accumulated losses, it can result in negative equity. This is generally when the losses are higher than the retained earnings and depletes the retained earnings in the company. In simple words, negative stockholders’ equity could mean that the company incurred losses for a prolonged time so that existing retained earnings and funds from issuing stock were not sufficient.
b) Large Dividend Payments
When a company uses retained earnings or exceeds shareholders’ equity, it would lead to negative equity.
c) Borrowing Money
The company borrows to cover accumulated losses instead of issuing more shares through equity funding.
How to find out if you are in negative equity as an individual?
Let’s assume you have a home loan, and you want to know if you are in negative equity or not. For this, please check the amortization schedule or the loan statement to find out the outstanding balance on loan. Compare the figure with the current market rate of the property. If the property’s value is below what you owe, then you are in negative equity.
To sum up, negative equity is considered a warning sign that an individual or a company is in financial distress. It could mean that the individual or company has spent its earnings/income and has borrowed in excess that the repayment ability is squeezed.