Equity

At its core, equity represents the value of an asset after subtracting the total amount of all liabilities (debts) against that asset, including car finance obligations. Simply put, it’s what you truly own free and clear. It highlights the owner’s stake or their net worth in something, indicating the portion of an asset’s value that isn’t claimed by creditors. It’s important to note that the specific meaning and implications of equity can vary depending on the context in which it’s used.

Equity in Homeownership

In the context of homeownership, homeowners’ equity is defined as the difference between the current market value of a property and the outstanding balance of all mortgages or liens (legal claims against the property) on that property.

How Equity Grows

Home equity isn’t static; it grows over time through a couple of key mechanisms:

• Mortgage Payments: With each mortgage payment you make, a portion goes towards the principal – the original loan amount. As you consistently reduce the principal, the amount you owe to the lender decreases, and your ownership stake (equity) correspondingly increases. In the early years of a mortgage, a larger portion of your payment goes towards interest, but as the loan matures, more of your payment targets the principal, accelerating equity growth.

• Property Appreciation: The housing market can fluctuate, and if the value of properties in your area increases, your home’s market value may also rise. This appreciation directly adds to your equity, even if you haven’t made additional mortgage payments. For example, if you bought a home for $500,000 and owe $400,000, your initial equity is $100,000. If the market value increases to $550,000 and your mortgage balance remains the same, your equity grows to $150,000.

Accessing Your Home Equity

The equity you build in your home can become a valuable financial asset that you can potentially access through various means:

• Home Equity Loans: This is a type of second mortgage where you borrow a lump sum of money based on your available equity. The loan has a fixed interest rate and a fixed repayment term. Home equity loans can be used for various purposes, such as home renovations, debt consolidation, or other significant expenses.

• Home Equity Lines of Credit (HELOCs): A HELOC is also a second mortgage but functions more like a credit card. You’re approved for a maximum borrowing limit based on your equity, and you can draw funds as needed during a “draw period.” You typically only pay interest on the amount you’ve borrowed. HELOCs often have variable interest rates. They offer flexibility for ongoing expenses or projects.

• Cash-Out Refinance: This involves replacing your existing mortgage with a new, larger mortgage. The difference between the new loan amount and your existing balance is provided to you in cash. This allows you to tap into your equity while also potentially changing your mortgage terms or interest rate.

Equity in Investments (Shares)

In the realm of investments, particularly on the stock market (or share market, as it’s often called here), equity refers to shares of ownership in a publicly listed company. When you buy shares in a company, you are purchasing a small piece of that business. The individuals or entities who own these shares are known as shareholders or equity holders.

As equity holders, shareholders have a claim on the company’s assets and earnings. This claim is usually proportionate to the number of shares they own. If the company is profitable, shareholders may receive a portion of those profits in the form of dividends, and the value of their shares may also increase (capital growth).

There are typically two main types of equity in the form of shares:

• Ordinary Shares: This is the most common type of share. Ordinary shareholders usually have voting rights in company matters, such as electing the board of directors and voting on significant corporate decisions. However, in the event of liquidation (the company closing down and selling its assets), ordinary shareholders have a lower priority claim on the remaining assets compared to bondholders and preference shareholders. The potential for return on ordinary shares primarily comes from capital growth and dividends, which can fluctuate based on the company’s performance.

• Preference Shares: Preference shares are often considered a hybrid security with characteristics of both shares and bonds. Unlike ordinary shares, preference shares typically do not come with voting rights. However, preference shareholders generally have a higher priority claim on the company’s assets and earnings than ordinary shareholders. They often receive fixed dividends at a specified rate, which must be paid before any dividends are distributed to ordinary shareholders. In case of liquidation, preference shareholders are also paid out before ordinary shareholders but after bondholders. Preference shares tend to be less volatile than ordinary shares and can provide a more stable income stream through their fixed dividends.

Equity in Business Ownership

In the context of business ownership, business equity (also known as owner’s equity or shareholders’ equity, depending on the business structure) represents the residual interest in the assets of a company after deducting its liabilities. Essentially, it’s what would be left over for the owners if the company sold all its assets and paid off all its debts.

Business equity signifies the owners’ stake in the company – the portion of the business that truly belongs to them. It’s a fundamental measure of the company’s financial health and stability.

On the balance sheet, business equity is calculated using the basic accounting equation:

$\text{Equity}=\text{Total Assets}-\text{Total Liabilities}$

This equation highlights that equity is the net worth of the business from the owners’ perspective.

There are different forms of business equity, including:

• Retained Earnings: This represents the accumulated net profits of a company that have not been distributed to the owners (shareholders) as dividends. Instead, these profits are reinvested back into the business for growth, expansion, debt reduction, or other strategic initiatives. Retained earnings are a significant component of owner’s equity, reflecting the profits the company has generated and kept over time.

• Contributed Capital: This refers to the total amount of money or other assets that the owners (shareholders) have directly invested into the company. For corporations, this often includes the value of ordinary and preference shares issued, as well as any additional paid-in capital (the amount investors paid above the par value of the shares). Contributed capital represents the external funding provided by the owners to start and grow the business.

Key Concepts Related to Equity:

Understanding equity requires familiarity with these related concepts:

• Asset: Something of economic value that an individual or entity owns or controls, with the expectation that it will provide future benefit. Examples include a house, shares, a car, or equipment for a business.

• Liability: An obligation to another party, representing something you owe. Examples include a home loan (mortgage), a car loan, credit card debt, or business loans.

• Market Value: The current price at which an asset could reasonably be sold in the open market. It’s the prevailing value based on supply and demand.

• Appreciation: An increase in the value of an asset over time. For example, a house or shares might appreciate in value due to market conditions or company performance.

• Depreciation: Conversely, depreciation is a decrease in the value of an asset over time. This is common for items like cars and some types of equipment due to wear and tear or obsolescence.

• Leverage: This involves using borrowed money (liabilities) to increase the potential return of an investment. While leverage can amplify gains if the asset appreciates, it can also significantly amplify losses if the asset’s value decreases. For instance, taking out a large mortgage to buy a property is a form of leverage.

Why is Equity Important?

Building and understanding equity is crucial for several reasons:

• Wealth Building: Building equity in assets like your home and investments (shares) is a fundamental way to accumulate long-term wealth. As you pay down your mortgage and your property appreciates, your home equity grows. Similarly, as the value of your shares increases, your equity in those investments grows. This accumulated equity represents a significant portion of your net worth.

• Financial Security: Equity provides a valuable financial cushion. For example, having substantial equity in your home can offer a sense of security. It can also be a source of funds in the future through options like downsizing or accessing home equity loans or lines of credit for unexpected expenses or opportunities. Similarly, liquidating some of your shareholdings can provide funds when needed.

• Borrowing Power: Having equity in assets can improve your access to credit and potentially lead to better loan terms. Lenders often view individuals with significant equity as lower-risk borrowers. For instance, a large deposit (representing a higher initial equity stake) can help you secure a mortgage with a lower interest rate. Similarly, having a strong net worth due to equity in various assets can make you a more attractive loan applicant.

• Ownership Rights: Equity often comes hand-in-hand with ownership rights. For shareholders, owning equity in a company (in the form of shares) can grant voting rights on important company decisions, allowing you to have a say in the direction of the business. Similarly, the equity you build in your home represents your increasing ownership and control over that asset.

Examples of Building Equity:

Here are some practical examples of how equity is built in different scenarios:

• Making mortgage payments that reduce the principal: Each time you make a mortgage payment, a portion of that payment goes towards reducing the outstanding loan balance (the principal). As the principal decreases, the equity you hold in your home increases.

• Investing in shares that appreciate in value: If you purchase shares in a company and the market value of those shares increases over time due to the company’s performance or market conditions, the equity (value) of your investment grows.

• A business increasing its profitability and retained earnings: When a business generates profits and chooses to reinvest those earnings back into the company rather than distributing them as dividends, its retained earnings increase. This growth in retained earnings directly contributes to an increase in the overall equity of the business.

• Paying down a car loan: Similar to a mortgage, a portion of each car loan payment reduces the principal balance. As you make these payments, your equity in the vehicle increases. Once the loan is fully paid off, you have 100% equity (assuming the car still holds value).

• Investing in managed funds or ETFs that appreciate: When you invest in managed funds (like unit trusts in Australia) or Exchange Traded Funds (ETFs), the value of your units or shares can increase if the underlying assets (e.g., shares, bonds, property) within the fund appreciate. This increase in the value of your holdings builds your equity in the investment.

• Home renovations that increase property value: Investing in renovations that enhance your home’s market appeal and functionality can lead to property appreciation. This increase in value, while your mortgage balance might remain the same, directly contributes to your home equity.

• A private business owner reinvesting personal funds: If an owner of a private business invests their own money into the company, this directly increases the contributed capital, a key component of the business’s equity.

• A startup attracting venture capital: When a startup company sells shares to venture capitalists in exchange for funding, the investors gain equity in the company, and the overall shareholders’ equity of the business increases. This capital infusion fuels growth and increases the company’s net worth.

• Collecting valuable assets that appreciate: Certain assets like artwork, antiques, or rare collectibles can appreciate in value over time. As their market value increases, the equity you hold in these tangible assets grows.

• Paying off credit card debt: While not directly building equity in an asset, reducing your credit card balances increases your overall net worth and improves your financial standing, effectively increasing your “equity” in your personal financial situation (assets minus liabilities).

Conclusion:

Equity is a fundamental concept that represents ownership, value, and a direct stake in an asset or business, even when considering financing options like a bad credit car loan where the initial equity might be lower or the terms less favourable. Whether it’s the ownership stake in your home, the value of your share portfolio, or the net worth of a company, understanding equity is crucial in personal finance, investing, and business. By understanding how equity is built and managed in different contexts, you can make informed decisions to grow your wealth, enhance your financial security, and appreciate the true value of your assets and ownership.