When the value of an asset (which was financed using debt) falls below the amount of the loan/mortgage that is owed
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What is Negative Equity?
The concept of negative equity arises when the value of an asset (which was financed using debt) falls below the amount of the loan/mortgage that is owed to the bank in exchange for the asset. It normally occurs when the value of the asset depreciates rapidly over the period of use, resulting in negative equity for the borrower.
Summary
- Negative equity occurs when the value of a borrowed asset falls below the amount of the loan/mortgage taken in lieu of the asset.
- Negative shareholder equity is a similar concept, whereby the company incurs losses that are greater than the combined value of payments made to shareholders and accumulated earnings from prior periods.
- For assets, negative equity can appear due to a reduction in the asset value or for companies if there is a large dividend paid, or there are significant accumulated losses.
What is Positive Equity?
To understand negative equity better, it is important that we first understand what positive equity is. A typical asset that is financed by a loan is denoted as positive equity for the owner.
For example, a person puts up a portion of the money as a down payment and purchases a house. Because the person did not pay the entire amount of the house, but he still owns the property, it counts as positive equity.
Positive equity can grow when the value of the borrowed asset goes up or the amount of the loan owed to the bank in lieu of the asset goes down.
Negative Equity – Implications
Negative equity can prevail under several circ*mstances. Below, we identify three scenarios and describe its implications to the concerned parties:
1. Negative equity for an asset
Negative equity for assets is common in the housing and automobile sector. A house or car is normally financed through some sort of debt (such as a bank loan or mortgage). The price of a house can decline due to fluctuating real estate prices, and the price of a car can fall due to rapid use (depreciation). When the value of the asset drops below the loan/mortgage amount, it results in negative equity.
Another related concept is negative amortization. It happens when the value of the asset remains constant, but the amount of the loan balance goes up. It can be due to the borrower not making sufficient repayments to the lender.
2. Negative shareholder equity
For listed companies, at times, a negative balance can appear for the equity line-item of the balance sheet. It happens when the company’s liabilities exceed its assets, and in more financial terms, the company’s incurred losses that are greater than the combined value of payments made to shareholders and accumulated earnings from previous periods.
A typical example of negative shareholder equity is when significant dividend payments are made to investors, which erode the retained earnings and make the equity of the company go into the negative zone. It is usually a sign of financial distress for the company.
3. Negative net worth
Net worth is used in the context of individuals. A person who has negative equity is said to have a negative net worth, which essentially means that the person’s liabilities exceed the assets he owns.
A common example of people who have a negative net worth are students with an education line of credit. Although student loans allow people to acquire an education, which, in turn, makes them more financially stable, it cannot be counted as a physical asset. Therefore, while the student loan is being repaid, the person who owns the loan has a negative net worth.
Example of Negative Equity in the Real World
Figure 2 illustrates an example of how to compute negative equity in the real world. A person buys a car that is worth $50,000 in the market, and he finances it using a loan with an interest rate of 5%, which needs to be paid over five years.
Using the given data, we can build a loan amortization schedule similar to that in Figure 3 (some rows are hidden for simplicity). The monthly payment comes out to be $1,063 (which includes the principal repayment and the interest charged).
Suppose the person drives the car for 200,000 kilometers over two years and wants to trade in the vehicle afterward. As the car has been used excessively, the depreciation and high mileage have resulted in the car being valued at $10,000 in the market.
Going back to our loan amortization schedule (Figure 3), the outstanding amount on the loan is $28,460 at the end of two years. We can see that there is a large difference of $18,460 between the value of the loan and the value of the asset. The amount is negative equity.
More Resources
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