The Loans Canada team sits down with Gary Schwartz of the Canadian Lenders Association to talk about open banking.
What is Negative Equity?
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Equity is defined as the total value of an asset less the owed obligations. Individuals want equity in their assets to be positive because it means they will make money if they were to sell the asset. Sometimes individuals do not have the fortune of positive equity, instead, they have the burden of negative equity. When the total obligations related to an asset exceed the total value, negative equity occurs. Negative equity becomes problematic when you want to sell an asset. This is because the proceeds of the sale will not cover your outstanding debt meaning you will have to pay the difference, which is equal to the total negative equity amount.
Unfortunately, it is impossible to avoid negative equity entirely because no one can predict what the value of an asset will be in the future. Some assets are more prone to negative equity than others, such as cars, because they depreciate at a rapid rate. Even though negative equity can’t always be avoided, it’s still in your best interest to learn about what it is and how to calculate. This way, if you ever need to deal with negative equity, you’ll be equipped with the necessary information.
Learn how to build home equity is Canada, click here.
How to Calculate Negative Equity
To calculate negative equity, you will need two pieces of information. First, you will need to know the market value of your asset. The market value is equal to the amount of cash you would receive if you were to sell your asset today. It is challenging to get a number that is exact, to find a reasonable estimate, do some market research on your car. Second, you will need to know the total amount you owe against your asset. The amount you owe on your asset would consist of a loan, lien or any other debt related to the asset.
Once you know the market value of your asset and your total debt, you use the following formula: market value – total debt = equity. If the number you get is negative, the debt exceeds the market value, therefore, you have negative equity in your asset. Below is an example.
Your car is worth $5,000 on the market, but you owe $6,000 toward your car loan. The negative equity in your car is $1,000 ($5,000 – $6,000). If you were to sell your car today, you would need to come up with the extra $1,000 to pay off your car loan.
What Caused My Negative Equity?
Sometimes negative equity is a result of a poor financial decision while other times it is a result of market conditions. To ensure that you avoid making a poor financial decision or understand why you have negative equity, below is a list of common reasons equity in the negative develops.
- No down payment. Without a down payment, the total amount of your loan will be higher. If the asset you purchased declines in value, the high loan balance can cause negative equity.
- Interest rate too high or loan term too long. Higher interest rates mean you will owe more money toward your loan. The high cost could work against you causing negative equity. As for loan durations, extending the term is great if you want lower monthly payments, but you end up paying more in the long run. This could also cause negative equity.
- You couldn’t afford the asset you purchased. When you’re out shopping, it’s easy to get caught up in all the bells and whistles. Sometimes this results in individuals purchasing something they can’t afford. This is especially true with cars. If you buy the newest car on the market, the value will depreciate faster than you can pay off your car loan resulting in negative equity.
Do you know what your LTV ration is? Learn how to calculate it here.
Can I Fix My Negative Equity?
It can be discouraging and disappointing to find out that an asset you own has negative equity. The good news is you can get out of negative equity by adopting a combative strategy. Below are strategic steps you can take to bring your equity back into the positives. Keep in mind that the strategy, or strategies, you use should suit your current financial situation and budget.
- Make extra payments or increase the payment amount. The more you put toward your loan, the less you owe against the asset which increases equity, given that the market value stays the same. It may seem unwise to make larger payments when you’re stressing about money, but if you can afford it, it is a good strategy for eliminating negative equity.
- Other sources of income. Getting a side job to increase your income and putting the extra income toward your loan can eliminate negative equity. By paying more toward your loan, you will be reducing the debt against your asset.
- Refinance. Refinancing a loan can get you better terms than what you currently have. This includes a lower interest rate or a longer loan term. More favourable loan terms mean that your loan will be cheaper which should increase equity.
- Sell the asset. You will have to come up with the negative equity amount to pay off the remainder of your loan by selling the asset. However, you will be cutting your losses now and avoid getting into deeper negative equity down the road. If none of the above options will work for you, selling the asset and cutting your losses is likely the best option.
Can I Trade in My Car That Has Negative Equity?
Yes, you can trade in a car with negative equity. Keep in mind that you will still be responsible for paying off the outstanding debt on the old car. Dealerships tend to evaluate the equity of a vehicle that is being traded in and use the equity amount as a credit toward the new car’s purchase price. If you have negative equity, you will owe the outstanding debts plus the new car’s price. To pay the negative equity debt, you can either pay it upfront or tack it onto the new car loan.
To learn more about trading in a car that’s not paid off, check this out.
Making the Most of Financial Decisions
It is impossible to avoid negative equity entirely because no one has the ability to predict the value of an asset in the future. Even though the risk of accumulating negative equity can’t be avoided, you can do your part by making informed and educated financial decisions. Before making a big purchase, make sure to do research on the asset, financial products, and lenders to ensure you’re getting the best deal possible. Understanding the market and finding the best deal will help you dodge negative equity.
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