Difference Between Insolvency And Negative Equity
In order to measure wealth and viability of economy, equity and solvency are important factors. Hence, when you come across terms like insolvency and negative equity, you may wonder what they are and what is the difference between the two. It goes without saying that both insolvency and negative equity are bad, but the degree of badness varies.
Insolvency basically refers to the inability of a person to pay debts that have become due. When this happens, the person is left at the mercy of the creditors, who have the right to begin involuntary bankruptcy procedure against the person in an attempt to get back the money that is owed to them.
In order to understand insolvency better, let us take an example. There is a company called X which has a debt of $100,000. This debt has to be paid back in a week's time, but the company is not worried as it has products in its inventory to the tune of $50,000 and the machinery and the plant is worth another $50,000. The company knows that it can sell its inventory for a hefty profit and repay its debts. However, before this occurs, a hurricane comes and destroys the entire inventory and causes damage worth $30,000 to the plant and machinery. As the company had no insurance to cover this loss and damage, it is saddled with a debt of $100,000 and assets worth just $20,000. Even if the assets are sold, the company will not be able to repay its debts. So, it ends up becoming insolvent.
Now coming to negative equity. Equity is nothing that is owed to the owner of the company after all the debts have been paid off. Therefore, negative equity is a situation where the debts are more than the assets of the company. To make it simpler, when the value of the assets of a company is less compared to the debts it has, it is known as negative equity.
Negative equity can also be explained better through an example. For instance, a person takes a mortgage to purchase a house. However, after some time, the value of that house declines as the real estate market plunges. In such a case, even if the person sells the house based on the prevailing rates, he or she will not be able to repay the mortgage amount. So, the house owner has negative equity on the house.
When you look at the difference between insolvency and negative equity, insolvency is the worse of the two. Negative equity can be changed by waiting for the recovery of the market or by putting in fresh capital into the business venture. The same cannot be done with insolvency unless a substantial amount is given to help bail out the company or business.
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