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What is equity?
Equity describes the value of an asset after subtracting the value of any liabilities on the asset. Commonly used to describe the value of a home and help purchase a new one, equity will be considered in taking out loans or paying off large bills. At the business level, equity can refer to the value of a corporation’s stock, and it helps determine the ability of the business’s owner or shareholders to continue funding its operations.
Throughout an asset’s existence, the value of the asset will be affected by liabilities attached to the asset. That difference is the asset’s equity, as described by the equation Equity = Assets – Liabilities. For example, if you have a car worth $35,000, but you owe $15,000 on a car loan, its equity is $20,000.
Three of the most common types of equity are
- Home Equity: To calculate home equity, you need to subtract the amount of money you owe on your home through mortgages or other liabilities from the value of the home. Home equity can be put up as collateral in what’s called a home equity loan to help finance large expenses such as remodeling or credit card consolidation.
- Owner’s Equity: Also commonly known as the “book value” of a company, owner’s equity is calculated using the money originally invested in the company and the earnings that the company accumulates during its operation. When the entity is controlled by shareholders, this is called shareholders’ equity.
- Equity Financing: Businesses sometimes use equity financing to raise capital. Using this method, a company typically sells stock, which gives investors partial ownership of the company in exchange for money.
While equity usually refers to a positive value, it can also be negative if an asset’s liabilities exceed its value.
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Roger has a balance on his mortgage of $100,000, and his home is valued at $379,000. He has $279,000 in equity. He may make use of a number of different options, such as
- Scenario A: Roger sells his house for its full value of $379,000. He pays off his mortgage and uses the equity to buy a new home. If he buys a less expensive home, he could pay for it in full. Otherwise, he could put a significant amount of money down to upgrade to a larger house.
- Scenario B: Roger wants to use some of his equity to pay off his credit cards and make some home improvements. He applies for a cash-out refinance on his mortgage. In the end, he has a new mortgage for $200,000. This gives him $100,000 in cash and $179,000 in remaining equity.
- Scenario C: Roger takes out a reverse mortgage to supplement his retirement income. This provides him a monthly payment based on the $279,000 in equity left in the house.