What is Equity?
Equity is one of those terms commonly thrown around in the world of finance, yet many people may only have a limited understanding of what it really means. Looking at the term, it can mean something different, depending on the situation. Home equity means one thing, while equity for small business owners means something different.
A Look at Home Equity
Taking a look at equity as it relates to home ownership, it’s the value an individual has invested in his or her home. Essentially, the formula for figuring this out is simple. Subtract the balance of the loan still outstanding on your mortgage from the appraised value of your home. The answer is how much equity you have invested in the property.
When you borrow money from a financial institution to purchase real estate, that bank has a vested interest in the property. The equity, which you earn by making your mortgage payments and reducing your debt, is how much of the home you own. As you gain more equity in your home, you can use that as a resource, or an asset. You may need to refinance your home or request a home owners line of credit. In either case, the more equity you own in your home, the more value you have to offer as collateral.
There are two ways homeowners can increase the equity they have in their home. Most obviously, making mortgage payments and repaying the loan reduces your debt and earns you greater interest in your home. Conversely, it also reduces the interest the bank has in the property.
Another way to earn more equity is by increasing the value of your home. If you can make improvements and have your home assessed at a higher value without increasing your debt, your equity will increase. In some cases, a boom in the real estate market may raise the value of your home without any action on your part. This will also give you added equity, at least until the housing market takes a downward turn.
Small Business Owners Earn Equity Too
The definition for equity in business is similar, but with a slight difference. The formula here takes the difference between your assets in your business and what you owe, which includes both debts and liabilities. By calculating this sum, you can determine how much you actually own in the business versus how much your debtors own. This can be helpful in deciding to sell a business or to consolidate your debts.
Just like home equity, the amount of equity in your business increases as your assets increase, but, in the case of business ownership, assets include more than just how much interest you have in the real estate. Assets also include your number of clients and customers, your influx of profits, how much your brand is valued, and the potential for growth and franchise opportunities.
In cases where you take your company public and allow people to buy stock in your business, you can also earn shareholder equity. As the owner of your business, you will retain the majority of shares, which earns you more equity as individual stock prices for your company rise.
Homeowners and business owners often use the equity they have invested in their homes to make improvements. For homeowners, this may just be to add more value or to make the home more enjoyable. For business owners, they may choose to use the equity in their company to make improvements or upgrades that will enhance their earning potential. In either case, it’s important to maintain a record of your investments, because banks expect you to prove how much equity you have invested, before considering a loan.