What is Negative Equity?

Negative equity simply means you owe more in debt than you have in assets. With the high degree of average debt per person in America, this situation occurs fairly often. For example, many people owe more on mortgages than they have in home equity. While some degree of debt is normal, too much debt and negative equity can lead to financial crisis in the long run.

How is Equity Calculated?

Equity is the sum of all assets minus the sum of all debt. You may only be thinking of large assets, like a home or car, but any type of asset counts. Jewelry, furniture and appliances are all considered part of your equity. Most people underestimate their equity because they forget these smaller items. Think of it this way: if you went bankrupt, what could a court sell in order to pay off your loans. Typically, any item with a market price has some amount of equity. For businesses, intangible objects may even represent equity. For example, would a competitor be willing to buy your company in order to have your client list? These softer assets are everywhere.

Why does Equity Matter?

On a day-to-day basis, your equity may not come into play. This is why it is easy to go into negative equity situations. However, when you need assets, your negative equity could be detrimental. Here are a few examples of when equity is important:

  • When you apply for a new loan - Your lender will look at your assets compared to your debts. If you have too much debt, you will pose a large risk to the lender, and you may not be able to get the loan. If you do get a loan, it will be at a higher interest rate.
  • Upon your death - What will you leave behind to your benefactors? Most people want to leave a valuable estate. People with negative equity only leave behind debt.
  • In a divorce - Instead of splitting equity in the items you own, you and your ex will have to divide the debt payments between the two of you. This can lead to a far more stressful resolution and a heavier burden.
  • When you retire - Your retirement is a very uncertain thing. Not everyone will have enough money coming in the door through pensions, social security and other payments. Having high debt payments at the end of your life can mean you will have to continue working into old age.

How to Build Equity

The best way to build equity is to only use credit when it is going toward a purchase that will turn into an asset. Take on debts to purchase items you will add to your balance sheet, not vacations, dinners or other expenses. If you follow this rule and make your payments, you will be headed toward positive equity in the future.