You’ve likely heard of the term equity, but what does it mean when it’s negative? In basic terms, negative equity occurs when the value of debt is greater than the value of the asset attached to it. As you can imagine, negative equity can be problematic and can impact other areas of your personal finances. If you’re ready to learn more, continue reading to understand what negative equity is and how you can resolve and avoid it.
Table of contents
- Negative Equity Defined
- What is negative equity on a car?
- Can a company have negative equity?
- What does negative return on equity mean?
- Can you have a negative debt to equity ratio?
- How do you get out of negative equity?
- Building Wealth by Avoiding Negative Equity
Negative Equity Defined
Negative equity is defined as a financial situation where the value of an asset is less than the debt against it. In other words, it’s the opposite of net worth. A common example is with car loans. If you buy a new car with a loan, the car can depreciate rapidly. As a result, the value of the car could drop lower than the balance owing on the loan.
However, negative equity can occur with any asset that has debt attached to it. But it’s more commonly experienced with depreciable assets. Normally land and houses do not experience negative equity because their value usually increases over time.
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How to calculate negative equity
Not sure where you stand? Here’s how to calculate the value:
- Estimate the asset’s value. This step can be tricky because market values fluctuate based on a bunch of different factors. However, find listings online for other assets that are similar to yours and use that as a benchmark to estimate your asset’s value.
- Determine the debt’s value. Find the most recent statement of your debt to determine what the current principal amount is. Remember, interest shouldn’t be included in the number because that’s the cost of the debt, not the asset.
- Calculate negative equity. Negative equity is calculated as asset value minus debt value. If the amount is negative, then you have negative equity and vice versa.
Is negative equity good or bad?
Negative equity is bad, not good. It takes away from your net worth which isn’t ideal. In addition, it can leave you in a vulnerable financial position. For instance, let’s say you can no longer afford the cost of a loan and the asset attached to it. So, you decide to sell the asset and use the proceeds to repay the loan. When you have non-positive equity, you’ll have to front the excess difference using other sources. The proceeds from the asset sale will not be enough. This can put unnecessary strain on your finances, such as having to get a gap loan or dipping into savings. This can result in a downward cycle into debt.
What is negative equity on a car?
As mentioned above, cars are the most common example of an asset that may incur negative equity. This phenomenon on a car happens when the value of the car is less than the outstanding balance of the loan against it. This is especially true if you purchase a brand new car because 30% of its value is lost the second you drive it off the lot. Let’s look at a more detailed example below.
Mary decides to purchase a 2023 car model for $70,000. Mary can’t afford a down payment, so she finances the entire amount with a 7-year installment loan. A year later, Mary has paid off $10,000 of the loan, but the value of her car is only $50,000 at this point in time. Mary has $10,000 in negative equity on the car because the loan principal is $60,000, but the value of the car is $50,000. If Mary wants to get out of this arrangement by selling the car, she will have to front the $10,000 to repay the loan, plus put forth the $50,000 proceeds from the car sale.
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Can a company have negative equity?
Yes, it is possible for a company to have negative equity. Like individuals, companies take on debt to purchase assets and expand their operations. The value of a company is assessed using the financial statements, specifically the balance sheet. If the value of the liabilities is greater than the value of the assets, the company will have negative equity.
Negative equity is concerning in all situations, including with businesses. With a company, it can be an indicator that operations are failing. Whether you’re a business owner or investor, equity that isn’t positive in a company should be investigated and remedied where possible.
What does negative return on equity mean?
To answer this question, let’s define return on equity first. Return on equity is a financial ratio used to assess the profitability of a company or certain investment decision. It is calculated as net income divided by shareholder’s equity (assets minus liabilities). The higher this ratio is, the greater the return and the more profitable the investment was.
But what about when the return on equity is negative? This essentially means there was a net loss resulting in a negative number. This isn’t ideal because it means the investment is losing money and not covering the cost of the debt against it.
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Can you have a negative debt to equity ratio?
The debt to equity ratio measures how much of a company is owned by creditors versus owners. It communicates the level of risk and leverage taken on by the company to conduct operations. It is calculated as total debt divided by equity (assets minus liabilities). However, the same theory applies to individuals. If you take out a lot of debt to finance your lifestyle, then you’d have a greater debt to equity ratio. But if you use your income and savings instead, then your debt to equity ratio is lower.
You can have a negative debt to equity ratio. Of course, this isn’t an ideal situation, but it can happen. It communicates negative equity, or that liabilities exceed the value of assets.
How do you get out of negative equity?
If you find yourself in a position with negative equity, it’s possible to turn it around. It’s recommended that you do to ensure you’re not in a vulnerable financial position. Here’s some tips on how to get out of this situation:
- Lump sum payment. By making a lump sum payment against your debt, the total balance will be reduced. For this to work well, ensure your extra payment goes towards the principal, not the interest.
- Refinance. You can refinance your loan to get a shorter term. This means you’ll be repaying the balance faster, thereby eliminating negative equity quickly. You will also pay less interest. However, it means a larger periodic payment.
A final option is to simply “drive through” the loan. In other words, just hold the negative equity and continue to repay the loan as agreed. Eventually, the loss will be eliminated the more payments you make over time. This is of course an option, but you will be carrying negative equity until the loan balance is more reasonable.
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Building Wealth by Avoiding Negative Equity
Ultimately, the goal with personal finance is to build wealth. This means purchasing assets with debt that is much less than the asset’s value. As you repay the debt over time, you’ll be building positive equity which contributes to your wealth. Here’s some tips on how to avoid acquiring a negative position:
- Question the price. If you’re about to buy an asset, definitely question the price. Don’t take it at face value. You can use similar market listings to determine if the price is reasonable or not. If the price is unreasonable, you can always negotiate with the seller.
- Use debt sparingly. Just because you can take out debt, that doesn’t mean you should. Try to only take on debt when you absolutely need it and the decision is aligned with your greater financial goals.
- Pay more upfront. If there’s a down payment in question, put forward as much as you can. This will reduce the total amount of the loan, which will reduce the risk of negative equity.
Negative equity can put you in a tricky situation, so it’s best to avoid it if you can. If you find yourself in this position, it won’t last forever, but do your best to reverse the situation. In addition, learn from your mistakes.
If you need help getting out of negative equity, Advisorsavvy is here. Fill out this quick questionnaire to get started today!