Definition of Equity
Equity is the dollar value of an asset minus any debt or liabilities owed against the asset. In real estate, home equity is the home’s current market value minus any mortgages or loans owed on the home. This means, your total home equity is the gross profit you would earn if you were to sell your home, today, minus any debts owed on the home.
Why is this term important?
The equity in your home is an asset. It’s the value of an asset that you truly own, as it the portion of the asset’s value that is not diminished or decreased because of an outstanding debt. The larger your initial down payment, the greater your equity is in a property. As you pay down your mortgage, the equity in your home grows as you owe less and less to your mortgage lender.
The size of your home equity is directly impacted by two factors: The amount of debt you owe on the asset and the value of the asset in the marketplace. If the debt owed is high, your equity share in the asset will be lower. If the fair market value of an asset decreases, so does the equity in that asset.
When you take out a mortgage, your lender uses the home as an asset with value to secure the debt. They do this by putting a lien on the property—in other words, they register a debt owed on the title of the property, allowing them to be first in line to recapture the debt, should you default on the mortgage. While your lender is registered on title, it does not own any portion of your home, they simply use the house as collateral for your mortgage loan.
As you pay off your mortgage, your equity portion in the house grows. As the housing market improves and property values increase over time, your home equity also increases. While your mortgage debt does not change, the value of your home does and the equity in your home is calculated by subtracting all debts from the current market value of the house. The resulting balance is the equity you hold in the home.
Let’s assume you purchase a house for $400,000 using a 20% down payment (which works out to $80,000). To cover the remaining balance, you take out a mortgage of $320,000. At this point in time, your home equity is 20% of the home’s current fair market value. Since the home is worth $400,000 and you contributed 20% towards that price, your equity is $80,000.
Now, let’s assume your home doubles in value, from $400,000 to $800,000, but you never increased your mortgage debt of $320,000. At this point, you would have 40% equity in your home. Your debt did not increase, but the value of your home doubled and this also increased your equity stake. You can calculate your home equity by dividing the current outstanding loan balance by the current market value, then and subtracting the result from one and convert to a percentage.
Examples of term
Assume you purchased a house for $400,000 using a 20% down payment (which works out to $80,000). To cover the remaining balance, you take out a mortgage of $320,000. At this point in time, your home equity is 20% of the home’s current fair market value. Since the home is worth $400,000 and you contributed 20% towards that price, your equity is $80,000.