The term equity applies to various assets including real estate, stocks, a business, and the law. This section will explore the different types of equity with particular emphasis on the most common equity-equity in real estate.
Real Estate Equity
In the context of real estate, equity is the value of property minus all loans and liens. It is the net difference between how much something is worth and how much debt the collateral has. The higher the equity, the greater amount of money a seller can get for selling those assets.
This concept is very important when determining qualification of a borrower for a loan. A lender typically does not extend financing when there is no more than 30% equity in the property.
Having equity in one’s property is the same thing as being worth that amount of equity. For example, if someone has $250,000 equity in their property, that means they are worth at least $250,000. In other words, equity is money. Equity is created through growth and payments made towards the property, whether it be a down payment or mortgage payments that have reduced the value of the property.
Equity in a property is almost always the most significant indicator of an individual’s net worth. This is why homeownership is such an important indicator of a healthy economy. When more people own real estate with equity in it, their net worth grows higher, therefore they can spend more money. More money circulated in the economy means higher economic growth. This growth ultimately sustains many industries including construction, retail, and labor.
Example of Equity in Real Estate
Assume Jason owns a property that is valued at $1,000,000. If Jason has a $500,000 loan on his property, he has $500,000 in equity. This means he has 50% equity in the property. In this scenario, assuming Jason has decent credit and documented income he would likely qualify to refinance his existing $500,000 loan or get a second mortgage.
How Lender’s Use Equity in Determining Borrower Loan Qualification
Lender’s provide financing based on the relative risk of providing that mortgage to the borrower. Before lender’s grant a loan they want to be sure they will get repaid for the money they lent. To secure their funds and avoid losing the money they lent, the lender will require the borrower to have equity. The more equity a borrower has, the higher likelihood the lender will get paid back the money they are owed because the borrower has “skin in the game.”
“Skin in the game” refers to the borrower having a lot to lose should they not be able to repay the loan. Having equity in a property is a borrower’s “skin in the game” because clearly the borrower would not want to lose their equity.
In the event the borrower fails to make mortgage payments the lender can foreclose on the property and sell the property to recoup their money. In this scenario, the lender would be entitled to the equity because the borrower loses their right to the equity after they stop making mortgage payments and the lender legally forecloses on the property.
Each business has a specific value. The value of a business is determined by its assets, monthly revenue, projected income, and others. The equity of a business is the total value of the assets of the business minus its liabilities.
Unlike real estate equity which is easy to calculate, business equity is difficult to determine because of the large moving parts in the transaction including the amount of people that are owed money (owners in the business), how much liability the business has, and the fact that is difficult to determine how much a business should be valued at.
In the event that a business is going through bankruptcy, the business will likely be required to sell the assets and use the money from the sales to pay off creditors in order of first and second position. If the government is owed money, they will clearly be the first in line to get paid back.
Owner’s of stock hold equity in a company. The equity of a company is distributed between stockholder’s. Much like other types of equity, the equity of a company and its subsequent distribution of stocks is based on the total amount of liabilities and subtracting this amount from the assets of the company.
A stock’s value is not based on equity share that is notated in the accounting statement of the company. Equity stock is based on the cash flow of the business, projected growth, current liabilities, future liabilities, and other undetermined measures such as future hiring or firing of employees.
Equity investments are the process of buying, selling, or holding stocks by an individual or company derived from gains and dividends. Parties that hold equity in investments generally have the right to vote for decisions that the company makes.