Real estate equity is one of the most used terms amongst real estate investors. So, if you are wondering what is equity in real estate, then here is our simplified guide for you.
Understanding the fundamentals is very important when investing in real estate. Especially if we are talking about the terminology associated with it. And real estate equity is one that you must understand.
What is Equity in Real Estate: Definition
Simply put, the definition of equity in real estate is the difference between the fair market value of the property and the amount of money you owe on the mortgage. Calculating real estate equity is simple. All you have to do is deduct the mortgage value from the fair market value of the property.
What is Equity in Real Estate: Equity in Action
Here is an example to demonstrate what is equity in real estate:
Let us suppose that you are buying an investment property that is worth $250,000 in fair market value. You apply for a mortgage and the lender requires that you pay 20% in down payment. In this case, a 20% down payment would be $50,000. However, you have $60,000 that you are willing to pay down. So, the lender agrees to lend you $190,000. So, you are still wondering what is equity, right?
Here’s the deal, in this case, equity is the money you have actually put into this investment. How to calculate it? Easy! Deduct the amount of money your lender gave you ($190,000) from the original property price ($250,000). Therefore, your equity is equal to the amount you have paid from your own pocket.
At this point, you are thinking this is an obvious example. However, this is the simplest scenario there is. Sometimes, a real estate investor finances the property with a mortgage, pays 20% down and still applies some renovations to the property. In this case, his/her equity adds up as they add the renovation costs to the initial down payment. So, if the investor had to renovate at the cost of another $20,000, that would be an equity of $80,000 instead of $60,000.
What is Equity in Real Estate: How to Build Equity on a Real Estate Investment
Equity is not a solid figure that you settle with. It is a figure that changes up and down as you spend more money on the property. In order for you to build up equity, you will need to do either of the following:
What is Equity in Real Estate: Repaying the Mortgage
All the while you are making mortgage payments, your property equity builds up. That, of course, includes any tax payments or insurance you pay for the property. Therefore, the more you are committed to your mortgage payments, the more equity you’ll be able to build.
What is Equity in Real Estate: Paying Extra on the Mortgage Principal
Paying extra money on the mortgage principal is another way of building up equity on an investment property. For example, if your mortgage principal is $600 a month and, if your financial situation allows it, you could pay $700 instead. This way you will be able to repay the mortgage faster as well as raise your equity.
What is Equity in Real Estate: Applying Improvements to the Property
Each time you apply any improvements to the property, you build up equity. However, the only way to know how much equity you built is when you decide to sell the property. The reason for that is that improvements and renovations lead to forced appreciation in the fair market value of the property. Therefore, the increase in value goes in your credit, not the lenders’, as you are the owner.
What is Equity in Real Estate: The Down Payment
The more you put for a down payment, the more initial equity you have on the property. Therefore, if you can afford to put a larger down payment, then go ahead and do it. After all, the more equity you own, the better chances you get on financing other investment properties to grow your business.
What is Equity in Real Estate: Property Appreciation
A real estate property tends to appreciate in value on an annual basis. Therefore, when your investment property appreciates, it plays in your favor. It means that the increase in value increased your equity as a result.
For instance, you bought a property that is worth $170,000. You paid $50,000 in down payment and the rest ($120,000) was covered with a loan. 4 years later, you decided to sell it and the property is worth $200,000 which is an increase of $30,000. This means that your equity is worth $80,000 + whatever you have paid for the mortgage during these 4 years. So, if we suppose that you have paid back $20,000 during the past 4 years, then your equity would be $50,000+ $30,000+ $20,000 = $100,000. However, same as with the application of improvements, it is hard to determine the exact equity value unless you decide to sell the property or get a professional to appraise it.
What is Equity in Real Estate: How Your Equity Decreases
As there are factors that help build up equity, there are also factors that cause it to decrease. Thus, here are the 4 important factors that result in a decrease in equity:
Getting a home equity loan is definitely going to cause your equity to decline. This is because you are putting your equity as a guarantee for the loan. However, this is a great way for buying an investment property with little money on hand.
A Decrease in Fair Market Value of Rental Property
If the real estate market value crashes at any point in time, your property’s value will automatically decline. Let us take the previous example (the property you bought for $170,000 with a $50,000 down payment). Let’s suppose that the market crashed and your property is worth $130,000. Despite the $50,000 in equity that you had, the property’s value decreased by $40,000. If you were to sell the property and repay the mortgage at once, you will only be left with an equity of $10,000 ($130,000 – $120,000 = $10,000) instead of $50,000.
Any damages that affect your property will cause you to fix them. This will automatically negatively affect your share of equity unless you have an insurance policy that covers it.
Lack of Maintenance
Neglecting your property’s condition is not in your best interest. Keeping up with repairs and maintenance, on the other hand, ensures that your equity share is building up.
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