Negative equity takes place when the real estate property’s value is lower than the outstanding balance on the debt which was taken for buying the property. The value of negative equity is calculated by finding the difference between the current value of the property and the remaining amount of debt.
Negative equity occurs when the debt of the company is higher in comparison to its asset’s value. When a company reaches this situation, it indicates the indebtedness of the company because of heavy reliance on loans. Negative equity arises due to accumulated losses, and these losses are carried forward and are projected in the balance sheet of the company as retained earnings.
The concept of negative equity is not limited to organisations but are applicable to individuals as well. For instance, an individual may encounter a situation in which the value of their assets is decreasing continuously over the years, however, the amount the individual owes to the financial institutions is higher than the value of the asset.
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It is crucial to ascertain the presence of negative equity as it can cause issues for both buyers and sellers. For instance, Mr X bought a house on loan, which is yet to be paid back and the house is also protected through insurance. The value of the house has diminished over the years. Through insurance amount also, the owner of the house (Mr X) will not be able to repay the loan amount. In case, Mr X is not able to repay the loan because of negative equity, then the responsibility to repay the loan will be transferred to the insurance company.
When an individual or organisation purchases a property through mortgage and a period of recession, depression or housing bubble collapse is around the corner, then the phenomenon of negative equity occurs as the value of the property falls dramatically. For example, an organisation invests $500,000 in real estate with a mortgage of $450,000. Due to the recession, the market value of the real estate falls to $375,000, then the organisation will have negative equity in the real estate. In the example, the organisation has $75,000 more mortgage in comparison to the value at which it will sell in the current market.
When the outstanding amount on a mortgage is higher than the current value of the property, then the mortgage, property owner and the property are tagged as underwater.
During the financial crisis of 2007 and 2008, the underwater mortgage was a very common phenomenon among real estate owners, especially during the peak of the financial crisis because the prices of the houses deflated considerably. The negative equity had a widespread impact on the economy as a whole. The house owners with negative equity had faced loss and found it difficult to pursue work in other states and areas due to losses after the sale of the property.
Negative equity and mortgage equity withdrawal are different concepts. Mortgage equity withdrawal is the elimination of the equity from the value of a property by using a loan against the market value of the real estate. The equity withdrawal reduces the current value of the property in the market by adding new labilities against it.
Accumulated losses – Negative equity can occur due to accumulated losses over the years or for a continuous period that is carried forward. In the balance sheet, within the shareholder’s equity, retained earnings contain the amount of the left-over profit which will be used for paying debts, dividends or to reinvest. When the company show a net loss, then the loss amount is carried over to the retained earnings and the amount is deducted from the retained earnings of previous year.
Borrowing money – When a company uses borrowing rather than issuing shares, then the company’s balance sheet can show a negative balance of shareholder’s equity. When the funds are raised through equity funding, then the balance sheet will indicate a positive balance in the shareholder’s equity. When the accumulated losses are combined in the shareholder’s equity, the balance will be negative. The incurred debt will be seen as the liability. The company can cover their losses through borrowed funds however, the balance of the shareholder’s equity will remain negative.
Large dividend payment – When a company pays large dividends by exhausting its retained earnings or if the payments exceed the shareholder’s equity, then the company would show a negative balance. With the conjunction of the negative balance and large dividends, pay-out can result in the occurrence of negative equity.
Amortization of intangible assets – The transactions related to amortisation of the assets such as trademarks or patents (intangible assets) are recorded in the balance sheet’s shareholder’s equity section. It might exceed the balance of the shareholder’s equity.