The term 'Equity' is included in the Real Estate edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here...
Equity represents the homeowner’s total dollar amount of ownership in their property. Determining equity is a simple calculation. It is found by taking the home’s assumed fair market value and subtracting out the balances of liens and debts secured by the property along with the mortgage balance that is still unpaid. As a home owner pays down the mortgage, reducing the outstanding principal balance, the equity of a home owner goes up. It similarly increases as the property gains in value. To obtain one hundred percent equity in their property, home owners have to pay down both any outstanding debts that are secured by the property and the full mortgage.
Associated with the equity value of a home is the LTV, or loan to value ratio. This loan to value ratio proves to be a means of stating the property’s value as against the total dollar amount of your actual loan. The loan to value ratio is simply figured up by taking the amount of your loan and dividing it by your property value. Alternatively, you could divide the amount of your loan by the purchase price or selling price, whichever of the two is the lower amount.
An example helps to illustrate the concept. If you were to purchase a $300,000 house, you might put down a $60,000 down payment using your money. The remaining $240,000 would be covered by taking out a mortgage. Dividing the $60,000 amount by the $300,000 home value yields equity of twenty percent. If you divide the $240,000 by the $300,000 home value, then you will get the loan to value ratio that amounts to eighty percent.
Should you determine later that you will sell this house, then the equity that you have will be concretely and accurately figured up for you. This will simply prove to be the fair market value of your house minus the loan that you still owe the bank on the house. Using the example from the paragraph above, consider what would happen if you lived in and made payments on your house for five years following the purchase.
In this time frame, your monthly mortgage payments lower the balance that remains on the loan to the tune of $10,000, diminishing it from $240,000 to $230,000. Besides this, over those five years, your home value goes up. This allows you to realize a selling price of $330,000. Since the balance that you owed is still $230,000, then your equity is simply figured by taking the $330,000 selling price and subtracting the $230,000 from it. This leaves you with a final equity value of $100,000. Once all selling costs and realty commissions are figured up and taken out, you would be able to utilize the $100,000 equity in order to invest or to put down the down payment on the next house that you purchase.
Naturally, this home value can cut both ways. Should the value on the home drop from $300,00 to $250,000 in the time that you own it, then your remaining equity would be only $50,000, less than the original $60,000 that you put into it upfront.