What is Equity? How to Empower Yourself By Building Equity
Equity is the measurement that results from subtracting a person’s or enterprise’s assets from their liabilities when they make investments. Essentially, equity is the value left over after you’ve paid all of your debts, with liability representing debt, and assets being classified as those things you own (e.g., cash, cars, homes, and other items that can be liquidated to exchange for cash).
With regard to home ownership, equity is the value left over once you subtract the balance of your mortgage from the fair market value of your home. When someone says they are “upside down” in terms of home equity, this means they owe more to the mortgage lender than their home is currently worth. Fair market value is based on both objective and subjective factors. It answers the question, “What would a reasonably knowledgeable person, who is freely participating in the transaction, willingly pay for a certain asset within a given time frame?”
Equity also applies to other assets such as stocks, equipment or business ownership, and the two primary ways it’s built is through loan repayment and price appreciation. Keep in mind that assets which depreciate in value over time also decrease in equity. A car is a perfect example. Pretty much the moment you drive that shiny new vehicle off the auto dealer’s lot, it begins to depreciate in value.
Much like how savings can lose value over time, if you took out a car loan, then your equity is almost immediately “upside down.” Certainly, you may keep the car in near-perfect condition, but should you resell or trade it in, you paid far more to the lender than you’ll receive.
Why Does Equity Matter?
The importance of equity is its liquidity, or ability to be exchanged based on a price that has stability. Cash is the most liquid of all assets and is the core of building a viable budget. Plus, cash is the most fluid in terms of how quickly you can exchange it for goods and services. A simple way to view equity is how much cash you’ll receive for an asset. So, the more equity you have, essentially the more cash is available to you—should or when it’s needed. As such, equity is your net worth directly related to your assets.
Equity can be leveraged to purchase a home or obtain loans. Lenders review your net worth as one of several measurements to determine how likely you are to repay the loan. Therefore, equity is inextricably linked to credit worthiness. Such is the reason mortgage lenders calculate your debt-to-income ratio. If you have a high income with a low amount of debt, then that points in the direction of having more equity. This is especially true if you own additional assets without any debt tied to them (e.g., a car you’ve paid off or if you own your home free and clear).
Ways to Leverage Equity
When you use your current equity to build an investment portfolio or improve other appreciable assets, then you are leveraging equity in a beneficial way. Home improvements tend to raise the fair market value of your home. Returning to school is also an investment that can prove to boost your income over time.
Though using equity to take a vacation might be tempting, it’s not classified as an appreciable asset unlike different types of investments. Certainly, everyone needs to get away and regenerate, and this may translate into energizing your productivity when you return. But prudent use of your equity by placing it towards continual investment returns on appreciable assets and activities will yield greater financial benefit in the future. Would your future self also like vacations (and with more frequency)?
If an emergency arises and you need access to a large sum of cash, you can apply for a home equity line of credit or borrow against that equity. Keep in mind that any additional debt you add may place you back into the “upside down” equity (also known as negative equity) situation. You can also withdraw money from a retirement savings account, but this should only be done knowing it will affect your preparedness for the future.
When you hit the age of 62, you can also sell back your home equity through a reverse mortgage. This allows you to receive cash payments in exchange for the existing home equity. This is still considered a liability, as it is a loan and you must pay it back. The U.S. Department of Housing and Urban Development lists additional and important specifics regarding a reverse mortgage on their website.
Equity is a valuable financial and investing tool that can help to enhance your lifestyle now and in the future, and improve your leverage as an advanced investor. Gaining equity and leveraging it in a responsible manner can make a significant difference in accumulating wealth and ensuring future financial stability.