What is Equity and How Do You Calculate It?

Have you ever heard the word equity thrown around by a “financial expert”?

Did you know what they meant? It’s okay if you didn’t.

I didn’t know what equity meant at one point either.

This post will change that.

This post is a continuation from my last two posts about assets and liabilities.

Assets, liabilities and equity make up a balance sheet and I’ll discuss that tomorrow.

Let’s start this post by diving into the definition of equity.

What is Equity?

Let’s start with Investopedia’s definition:

The value of an asset less the value of all liabilities on that asset.

Wow that doesn’t help. I honestly thought their definition would be better than that.

Let’s start with an example.

And then we’ll come back to the definition

What is an Example of Equity?

Pretend you are buying a rental home.

You know because you want to make a 20% return renting homes.

You start with the money you have. So pretend you have $10,000 to put toward a house.

You find a house for $100,000 and decide to buy it.

That $10,000 in your bank goes towards the house and the rest gets funded by a bank in the form of a loan.

So you have a $100,000 house with a $90,000 loan and $10,000 of your cash in it.

That $10,000 is equity. This is a simple example.

It gets more confusing with the value of your home changes.

Let’s say they value of your home goes up $110,000 immediately after you buy it.

I know this isn’t that realistic but I don’t want to confuse you with a change in loan balance.

I also don’t feel like calculating the change in the loan balance.

So at $110,000 the loan balance didn’t change. That’s still $90,000.

To make up the difference between $110,000 and $90,000, your equity had to change. You had $10,000 in cash and and now you have $10,000 in appreciation for a total of $20,000 in equity.

That’s a sweet deal to me. Double your money instantly!

Sounds like one of those late-night no-money down commercials. You know the one that promises you can buy property with no money down.

Don’t let my example or that commercial fool you. Doubling your money instantly isn’t realistic.

The Definition of Equity Revisited

Let’s look at that definition again:

The value of an asset less the value of all liabilities on that asset.

Now it makes more sense.

The value of an asset which was the rental home in our example and its value was $110,000. Then you subtract the liability which was the loan amount of $90,000 in our example.

When you subtract $110,000 from $90,000 you get $20,000. $20,000 is your equity.

It’s clear as mud now.

Summary

Equity is a little more difficult concept than assets of liabilities.

It’s because it requires math to find equity.

And it takes math to explain it.

But it’s important to understand equity and how much you have.

It’s a good indicator of financial strength.

But I’ll get into that tomorrow.

What is another example of equity?

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2 Comments

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