The term “equity” is used in different senses throughout the finance world, so you may be wondering, What is equity? Bottom Line Personal asked Eric Amzalag, CEO of Peak Financial Planning, for a definition of equity that sheds light on the many uses of the term.
What Does Equity Mean?
Broadly, the term “equity” refers to how much value you have in something that is at risk—a house, a car, a company. Don’t stumble over the “at risk” wording—houses and cars are always at risk, which is why we insure them…companies are at risk of going bankrupt. So equity is your ownership share in the value of the asset.
How to Calculate Equity
Equity is a percentage found using the simple formula Equity = Y/T x 100 in which Y means your current value and T means the asset’s total current value. In other words, divide the amount of the asset you currently own by the total current value of the asset, and multiply that figure by 100.
Example: You’ve just closed on a new home. The sale price was $400,000, and you put $30,000 down. Place the $30,000 above the fraction line and $400,000 beneath it to get 0.075. Multiply 0.075 by 100. Your equity in the home is 7.5%. As you make payments over the years, your equity normally grows. If you’ve been paying for 10 years, the portion of the home’s value that you’ve already paid for is likely higher than the 7.5% you owned at closing.
Equity Gotchas
Sometimes people with only a cursory understanding of equity miss three important points….
House equity is not based on your mortgage at closing
As years pass, the sales price and size of your mortgage at closing are no longer relevant to the equity calculation. Remember, the denominator is the current value of the asset, not what it cost 15 years ago.
An asset’s current value can be slippery
Some assets are easier to value than others. A home’s value is almost always an estimate, since you don’t really know how much it would bring on the market.
Equity can be negative
It’s possible for the asset to lose value even while you’re paying on it so that you end up under water.
Equity Investing
Equity trading refers to the buying and selling of stocks. Stocks fall under the “equity” heading because a stock position represents an ownership stake in a public company.
Other “Equities”
Shareholder equity is the portion of a company’s value owned by the body of shareholders after all liabilities are paid. It’s what the shareholders would get if the company liquidated and paid all its debts. This is typically reported as a raw dollar amount, not as a fraction or percentage.
Private equity refers to an ownership structure whereby investors purchase non-publicly traded companies to generate value. A private equity firm is a company that pursues this strategy.
