Equity in real estate is the difference between how much your property is worth and how much you owe.
Equity is often difficult to calculate for real estate novices, but it is essential to understand if you plan on being a part of the industry. As a real estate teacher, I’ve encountered many students who struggle to understand equity, but I’m here to help.
In this post, I’ll define equity and use examples to explain how it works. After reading this post, you’ll be able to define and calculate equity.
What Is Equity in Real Estate?
Equity is the difference between the home’s current value and the remaining mortgage or debts.
Equity in real estate usually refers to the value that determines the borrower’s share or stake in the property. If a borrower owns the property free and clear, it means they have paid off the mortgage completely. In this case, the equity is the total current property value in the real estate market. But, if the homeowner has an existing mortgage, the equity is the home’s value minus the mortgage.
Types of Home Equity
There are different types of equity, each with its own purpose. The following are the types of equity available:
- Home equity
- Shareholder equity
- Private equity
- Brand equity
How to Calculate Equity?
There are two important factors that help calculate equity. These factors are the property’s current value and the remaining mortgage balance to calculate equity. Follow these steps to calculate equity:
- Find out the property’s current market value. The current value can change if the borrower had purchased their property a few years ago. The borrower can consult a local real estate agent or use an online home price estimator tool to find the value.
- Once the borrower has determined the current value of their property, they can subtract their mortgage balance from it to get equity.
Return on Equity
Return on equity is a measurement tool that allows us to measure the return earned on equity. A real estate investment consists of a combination of equity and debt.
Debt comes from the lender, and equity comes from the buyer or investor. The borrower repays the debt to the lender in monthly installments. By paying the debt, the homeowner secures a part of the equity. At the time of buying the property, the equity is the down payment because that is the only amount the home buyer holds in the property. Return on Equity has the following formula for calculation:
ROE: Annual Cash Earned / Total Equity Investment
ROE is based on the total gain, which includes appreciation and cash flow. The annual cash earned is the net amount that the borrower will receive if the property is sold. Dividing this amount by the total amount the home buyer has already paid as a mortgage will give a percentage called Return on Equity.
Building Equity in a Property
Homeowners can build equity in their property in various ways. By increasing home equity, the homeowner can enjoy various benefits on the return on Equity. The following are the ways in which a homeowner builds equity in their property:
Making Mortgage Payments
The best way to increase equity in the property is by making mortgage payments. The borrower increases their share in the property by making regular payments on the existing mortgage. The mortgage balance decreases as the borrower makes monthly payments. But, their equity in the home increases. In some cases, the home buyer can make extra mortgage principal payments to build equity even faster.
Home Improvements and Repairs
Another way to increase equity in the home is by making home improvements and repairs. By making home improvements, the homeowner adds value to their property. If the home buyer improves the property, it increases its value. For example, if the home buyer builds a garage or renovates the kitchen, they will invest in the property, increasing their equity. Homeowners can use open-end mortgages or HELOCs to get funds for home improvement.
Making a Large Down Payment
The quickest way to build equity in the home is by making a large down payment. While the monthly mortgage payments allow the homeowner to build equity in an easy way, making a large down payment will enable it to do it faster. For example, the home buyer can put down around 10% to 20% as a down payment so they can tap into the equity faster.
While the homebuyer can build equity in their home, they can also lose it in certain circumstances. The borrower must take steps to make sure they don’t lose equity in the property. When the property value decreases, the homeowner also loses equity in it. Generally, if the property sells for a lower value, the homeowner will have a small equity. The following are the factors that can affect home equity and cause it to drop:
An Increase in Loan Size
When a person takes a home equity loan or refinances the mortgage, it can decrease their equity. By taking more loans, the mortgage balance increases and decreases the equity. After subtracting the mortgage balance from the current home value, there will be a small amount left in equity.
Aging or Deterioration of the Property
If the condition of the property deteriorates, its market value will decrease. The property value decreases if the nearby properties age or deteriorate too. If other houses in the area are selling for a lower value, chances are that all the properties will be sold at a decreased price. But the condition of the individual property also affects its price.
Changes in Market Condition
The value of the property is also affected by market changes. For example, if the economy of the country or the local real estate market is facing a crisis, the property value will decrease. When the market conditions change the property’s value also changes. This can increase or decrease the equity.
Uses of Home Equity
Home equity is the share of the homeowner in the property. Since home equity is not liquid, the homeowner can’t use it for carrying out expenses. To use home equity, one needs to take a home equity loan. The best way to take a home equity loan or HELOC is by requesting it from the current lender to which the borrower is making mortgage payments. Once the borrower obtains funds against their equity, they can use it for various purposes. Sometimes lenders also restrict how the home equity loan should be used. The following are the best ways to use home equity:
- Home Improvements
- College Fees and Costs
- Debt Consolidation
- Emergency Expenses
- Business Expenses
- Wedding Expenses
- Costs to continue education
Home improvement is one of the best uses of home equity because it adds to the property value. When the borrower borrows against home equity, equity decreases. But when they use these funds for home improvement, the property increases. When the property value increases, the homeowner’s equity also increases. Home equity can also be used for paying off debts. For instance, the borrower can use a home equity loan or HELOC to pay off personal loans.
Example: Suppose John purchases a home valued at $150,000. He got a loan at a rate of 6% and paid a 20% down payment which instantly increased his equity by $30,000 in the property. The remaining mortgage balance is $120,000, which he has to pay in a term of 20 years. After 10 years, John has the following balance:
- Existing mortgage balance: $76,965.17
- Interest rate: 6%
- Remaining term: 10 years
- Monthly payments: $1,143.05 (fixed)
At this point, John wants to know the equity in his home. He talked to a local real estate agent to determine the current value of his home. The real estate agent told him that the current value of his home had increased by $20,000. This means that the current value of John’s home is now $170,000. He calculated his equity in this home as follows:
Equity = Current Home Value – Mortgage Balance
= $170,000 – $76,965.17
John has an equity of $93,034.83 in this home after 10 years. After 10 more years, the loan will complete its term, and if John has paid off the mortgage completely, he’ll own the property free and clear. Any increase in the property value will also add to his equity.
Frequently Asked Questions
How Much Can the Homeowner Borrow Against Equity?
Most lenders will allow the homeowner to borrow only a certain percentage against their equity. This is called a home equity loan or HELOC, in which the borrower takes funds against their equity. The percentage and terms of this loan depend on the lender. In general, a loan-to-value ratio should be around 80% to 85% of the property’s appraised value.
Does the Value of a Home Decline?
Yes, the home value declines when the condition of the home deteriorates or the market condition goes down. For this reason, it is recommended to make home improvements to keep the home in a better condition.
What are the Drawbacks of Using Home Equity?
There are a few drawbacks to using home equity. When the borrower uses home equity, the mortgage balance increases, and equity decreases. Plus, if the borrower doesn’t make payments on the home equity loan, they might lose their property.
What to Know for the Real Estate Exam
Understanding equity is valuable for any real estate professional. It is the homeowner’s share in the property’s current value.
If there is no existing mortgage on the property, the homeowner owns the property free and clear. The equity, in this case, is the total current value of the property.
If there is an existing mortgage, the equity is the property value minus the mortgage balance.
To do accurate calculations, real estate students must have a clear concept of equity. If you are confused about the term, let me know in the comments. To learn more interesting real estate concepts, go through this extensive Real Estate Vocabulary.