What Is Equity
Every real estate investor must know what Equity is.
Equity = Asset - Liability. In other words, equity is equal to what you own minus what you owe. For example, let’s say you have a house that has a market value of $200,000 - this is what you own (asset). You owe the bank $100,000; this is what you owe (liability). Therefore, your total Equity is $200,000 - $100,000 = $100,000. But what does equity really mean and why is important to you? It means when you sell the house, that’s how much cash you will get from the house. If you look at the equation, it’s easy to tell there are 2 ways to increase the equity of the house. One way is to increase the home’s value, and the second is to reduce debt. There is another way to increase Equity called Sweat Equity.
3 Ways Increase Equity
Let’s make an example. We are buying a house with a market value of $100,000. We then ask the bank to lend us the $100,000 to purchase it. This means we have 0 equity in the house because the house is worth $100,000, but we owe the bank $100,000. We then make mortgage payments every month. The mortgage payments are the same for the next 15 or 30 years depending on what the term is on the loan. There are two parts in mortgage payments. Principal and Interest. Interest is simply the fee that we need to pay for the bank for borrowing the loan. Interest is how the bank makes money on this loan. Principal is the equity of the house. Let’s say the mortgage payment is $500 a month. Lets say the interest is $400 and the principle is $100. We are only putting $100 into equity. We increase the equity from $0 to $100 just by paying down the mortgage.
Increasing Home Value
The second way to increase home equity is to increase home value. Let’s use the same example. We buy a house for $100,000 and choose to do 100% financing. Then we spend $10,000 to do some upgrades in the house. We upgrade the kitchen and change to hard wood floors. Now the house is worth $120,000. The total equity is now $20,000. The good thing is, we only spent $10,000 to upgrade the house.
The third way to increase equity is what we call “sweat equity”. This is the most effective way to increase equity. Let’s use the same example above. There is a house on the market. We’ve done some analytic research and found that the market value is $100,000 for the house. For whatever reason, the house is currently selling for $80,000. Then, we do 100% financing where we borrow $80,000 from the bank and purchase it. Now we have $20,000 equity in the house because the house is valued at $100,000, but we only owe the bank $80,000. Sweat equity is the most effective method and has the lowest risk when investing in real estate. This is because we didn’t do anything to the house. We neither spent money for upgrades nor paid any mortgages. We’ve only invested some time and effort shopping around for deals in the housing market.