Equity Explained
Last updated
Last updated
Over the next couple of sections we will dive deeper into just how exactly a real estate investment would play out in a mock scenario. To start though, we need to define a term that gets constantly thrown around with home ownership and one that is a little hard to understand. And that is "equity."
In short, equity refers to the ownership interest or value that an individual or entity holds in an asset or company. It represents the residual interest after deducting liabilities from the asset's or company's total value.
Taking the model from the above video, let's look at the scenario of an individual purchasing a $500,000 home. The individual has $200,000 to put down on the purchase of the home, so a $300,000 mortgage is taken out.
There's two ways this individual builds equity in this home, whether it be through renting or through residing in it as their primary residence.
Taking a look at the mortgage payments for our example home, and assuming it's a 30-year mortgage with a 6% interest rate, we get an payment schedule that results in the following:
0
300,000.00
0.00
0.00
1
296,315.96
17,899.78
3,684.04
2
292,404.71
17,672.56
3,911.26
3
288,252.21
17,431.32
4,152.50
4
283,843.60
17,175.21
4,408.61
5
279,163.07
16,903.29
4,680.53
6
274,193.86
16,614.61
4,969.21
7
268,918.16
16,308.12
5,275.70
8
263,317.06
15,982.72
5,601.10
9
257,370.50
15,637.26
5,946.56
10
251,057.17
15,270.49
6,313.33
Total Equity Built
-
-
48,942.83
Year 0 starts with the full $300,000 loan. By Year 10, the remaining balance is $251,057.17. The borrower has paid $48,942.83 toward the principal, which represents the equity built through mortgage payments (excluding appreciation).
The other way equity is generated is through capital appreciation. Looking at the value of the home now, let's assume that the home appreciates annually at 2.5%. What we get is as follows.
1
$500,000.00
$12,500.00
$512,500.00
$12,500.00
2
$512,500.00
$12,812.50
$525,312.50
$12,812.50
3
$525,312.50
$13,132.81
$538,445.31
$13,132.81
4
$538,445.31
$13,461.13
$551,906.44
$13,461.13
5
$551,906.44
$13,797.66
$565,704.10
$13,797.66
6
$565,704.10
$14,142.60
$579,846.70
$14,142.60
7
$579,846.70
$14,496.17
$594,342.87
$14,496.17
8
$594,342.87
$14,858.57
$609,201.44
$14,858.57
9
$609,201.44
$15,229.94
$624,431.38
$15,229.94
10
$624,431.38
$15,610.78
$640,042.16
$15,610.78
Total Equity Built:
$140,042.16
Year 0 the home starts with a value of $500,000. By Year 10, the home's estimated value is $640,042.16. The owners home has appreciated by $140,042.16 which represents equity built through capital appreciation.
With homeownership, equity is built simultaneously through principle reduction and capital appreciation. That means the total equity built through ownership by year 10 is the sum of the two, which would $188984.99.
In summary, equity represents the ownership value of an asset after deducting any liabilities or debts tied to it. In the context of homeownership, equity refers to the portion of the home’s value that the homeowner actually owns, as opposed to what is still owed on the mortgage.
Equity in homeownership is built in two ways:
Principle Reduction - As homeowners pay down their loan, the principal portion of each payment reduces the mortgage balance, increasing equity.
Capital Appreciation - If the home’s market value rises due to demand, renovations, or economic conditions, equity increases.
And that the value of equity can fluctuate. Things such as market conditions, ability of a borrower to make payments, and external economic factors can cause equity to increase, or wipe it out entirely.
