Real estate 101: Equity

“Paying rent doesn’t build equity.” “Do you have any equity?” “We used our equity to put in a pool!”

Equity - everyone’s probably heard something about it but we don’t always know what it means. When building wealth through homeownership, equity is an important topic. Let’s explore what equity is and why it's essential to understand.

What is equity?

Equity in real estate is the portion of your property's value that you truly own. It's the difference between the current market value of your home and the outstanding balance you owe towards a mortgage or any other loans/liens against the property. Someone who buys a home entirely in cash, with no outside loans, possesses 100% equity in that property.

Here's a basic formula to calculate equity: Property Value - Owner’s Remaining Debt = Equity

For example, let’s say our friend Sam owns a home and still owes $400,000 on a mortgage loan. Sam sells the home for $1,000,000. The bank is repaid its loan and Sam gains $600,000 from the sale. Equity is what you walk away with if you sell your property - it could be a lot or it could be a little.

I like to think of equity and debt as plates on a scale. The more debt on a property you have, the less equity you possess. As you repay your debt, like a mortgage, your equity increases and the plates change.

In addition to paying down your debt, your equity will improve if the property’s value increases, or appreciates. Appreciation occurs because of many factors including the housing market, location desirability, interest rates, and improvements made. Property appreciation won’t get rid of your debt but it can help balance the scale.

Why is equity important?

  1. Financial Security: Equity represents your stake in your home. Paying down debt increases equity. This can provide a sense of financial security, knowing that you're building wealth through homeownership.

  2. Leverage for Future Investments: Home equity can be borrowed against for various purposes, such as financing home improvements, consolidating debt, or investing in other properties. This can be a valuable source of capital when needed.

  3. Resale Value: When you decide to sell your property, your equity determines how much money you'll pocket from the sale. More equity can lead to a more significant profit. This is a big difference between owning your home and renting it. When renters move, they don’t get any return on the rent payments they made. In contrast, many homeowners do receive a return based on their equity.

  4. Access to Better Loan Terms: Having a substantial amount of equity can make you a more attractive borrower to lenders. You may qualify to refinance your current loan for better terms, such as lower interest rates or higher loan amounts. These can save you money over time.

  5. Risk Mitigation: In the unfortunate event of financial hardship, equity can serve as a buffer. You may have the option to sell your home or tap into your equity to cover surprise expenses.

  6. Retirement Planning: For many, their home is one of their most significant assets. As you build equity, homeownership can become a valuable component of your retirement plan. You can choose to downsize, sell, or rent the property to tenants as a source of income.

Understanding and managing home equity can be crucial to financial planning. Homeowners can regularly track their equity and may choose to explore ways to increase it, like making extra mortgage payments or improving their home.

TL;DR

A homeowner’s equity is what they own outright - the difference between the value of the property and what they owe to the bank. The less debt on a property, the greater equity the owner has. Having equity in real estate can enhance financial stability, provide opportunities for growth, and contribute to long-term financial goals.

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