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What is the Difference Between Insolvency and Negative Equity

written by: Steve McFarlane•edited by: Rebecca Scudder•updated: 12/15/2010

Let's have a look at the difference between insolvency and negative equity.

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    Matters of owner equity and solvency are important measures of economic viability and wealth. Therefore, it is quite natural for someone to question the difference between insolvency and negative equity. Though both conditions are bad, they have different degrees of dreadfulness.

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    What is Negative Equity?

    Let's first have a look at the negative equity concept. In its simplest form, equity represents an owner’s interest in a company or asset after debts are paid off. Negative equity therefore represents a situation where liabilities completely engulf the ownership interest. In other words, negative equity occurs when the value of an asset is less than the debt that is held against it.

    Paying off debt - The difference between insolvency and negative equity 

    An example is a situation in which the value of a property falls significantly after a mortgage was taken out against it, which means that proceeds from selling the property won’t be able to pay off the loan in full. Another example of a negative equity situation is a case in which only a portion of the interest on a debt is being paid, therefore allowing the debt to grow above the value of the property being held against it.

    Is negative equity bad? Not in all cases. It really depends on how much the value of the asset has fallen below the total amount of debt that is owed against it. If the situation has occurred because of falling market prices, then that situation could soon reverse itself when the market recovers, or the negative equity situation can be remedied by paying down the debt.

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    What is Insolvency?

    Insolvency is a beast of a different degree. Insolvency is the inability to pay ones' debts when they become due, which leaves the debtor at the mercy of creditors, who may initiate involuntary bankruptcy procedures to recover their money.

    Let's look at an example. Lets say that Mills B Gone Ltd has a debt of $100,000, which becomes due in a week. Lets also assume that Mills B Gone has plant and machinery valued at $50,000 and inventory valued at $50,000. The company hopes to sell that inventory at a significant profit to pay the debt, but then a hurricane rolls in on the weekend and causes $30,000 worth of damage to the plant and completely destroys its inventory. If the company has no insurance, this unfortunate situation leaves the company with a debt of $100k and only $20k in assets, which is not enough to pay its debts, even if it can sell all its remaining assets before the debt becomes past due. In this scenario, Mills B Gone Ltd has become insolvent.

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    The Difference Between Insolvency and Negative Equity

    As we saw in the examples above, a negative equity situation can be remedied in many situations by waiting for the market to recover or injecting new capital. On the other hand insolvency is, almost always, a death sentence that’s nearly impossible to wiggle out of if a substantial bailout is not forthcoming.

    Image Credits:

    “Paying off debt - The difference between insolvency and negative equity" alancleaver_2000