If you’re interested in buying a house as an individual homeowner, or an apartment building as a property investor, you might understand the importance of “equity” as a concept. However, equity can be a nebulous term, especially for new real estate investors, and many people misunderstand how it’s used and applied.
Put simply, equity refers to the amount of ownership you have in a property. To figure out how much equity you have in a property, you need to take the market value of your home and subtract how much you owe on your mortgage or other loan. For example, let’s say your home is worth $250,000, and after a few years of owning it, you still owe the bank $190,000. The difference is $60,000, giving you $60,000 of equity in the home.
You can also think about it this way: you sell your home for $250,000, its market price. You must use some of the proceeds to pay off the $190,000 you owe the bank, so you’ll be left with $60,000—your net proceeds from the sale.
What Is Preferred Equity?
In some equity real estate investment opportunities, an asset will be distributed in the form of both common shares and preferred shares. Each of these share types represents a fractional share of ownership in the asset, with one major difference: preferred shares receive cash flows ahead of common shares. In other words, preferred equity holders will receive dividends before common equity holders.
Preferred equity is a complex topic, so if it interests you, make sure you do further reading to learn what preferred equity is and how it relates to real estate investing.
What Is Net Equity?
You may also need to think about your net equity as a homeowner. In the standard calculation in the introduction, you can figure out your gross equity—the amount of ownership you have in your home once you account for your mortgage. To calculate your net equity, you’ll need to factor in other expenses related to your home, often due when you sell the property. For example, you might owe a commission to the real estate agent selling your home, you could be responsible for closing costs like escrow fees and title charges, and you may need to pay off your unpaid property taxes. Your gross equity minus all these other expenses will yield your net equity—the amount of money you’ll receive after the sale of your property.
How Can You Increase Your Equity?
The more equity you have in your home, the greater your percentage of ownership will be. There are several ways you can increase your property equity, some of which are simpler than others.
To start, you can offer a bigger down payment. Most lenders will require you to put at least 5 percent down, though in some situations, you can offer as little as 3 percent. For a $200,000 home, this would mean $10,000 and $6,000, respectively. However, these would give you a starting equity of just $10,000 or $6,000, respectively, in the home. If you put down something bigger, like 20 percent, you can immediately start with a bigger ownership stake in the property.
If you get a mortgage or similar loan for the property, the next way to increase your equity is steady and reliable—you simply have to make your payments. If you’re in escrow, your monthly payment will likely include a combination of a payment on your principal, an interest payment, a partial payment for property taxes, and a payment for home insurance. The amount of money you contribute to your owed principal will accumulate over time, adding more to your equity naturally.
The other way to increase your equity is to increase the market value of your home. For example, if you have a $250,000 home and you owe $190,000 to the bank, you’ll have $60,000 in equity. But if you do some major repairs or initiate a renovation that increases the value of your home to $260,000, you’ll have $70,000 in equity. Keep in mind that not all home renovations are going to have the same value; some have a high return on investment (ROI), adding as much to the value of your home as they cost to instate. Others are less helpful and may cost more than they’re worth.
Better understanding your equity in a property can help you make smarter property buying decisions. If equity is important for your long-term financial goals, you can use strategies like making a higher down payment and committing equity-centric renovations to your home to improve your total equity. Make sure you run calculations for your gross equity and net equity on your regular basis, so you understand how much of your net worth is tied to this property.