Understanding Equity - What it means and the factors that affect its worth

Dec. 5, 2019, 11:48 a.m.

 

Trees are perennial in nature, and commonly grow into very broad stems or trunks that support a system of branches and leaves. Metaphorically, the overall composition of trees have been used to describe the origins, structures and functions of various ideas and establishments.
And Equity can be understood better in this way. A virtuous system of intricate subsidiaries, each having a slightly different reference and application. 

 

Although this article only looks at the general makeup of equity, its conforming subsidiaries may become articles of their own such as owner’s equity, negative equity, stock equity and so forth, in due course. 



What is equity?

The following example illustrates the relevance of equity in a real estate setting:

Imagine you purchased a house for K500,000, made a 10% down payment (10% of K500,000 = K50,000) and got a loan to cover the remaining K450,000. In this illustration, your equity is 10% of the property’s value, which is K50,000 (10% of K500,000). The property is valued at K500,000 and you contributed K50,000 (or 10% of the purchase price). Technically, in spite of you being the rightful owner of the property, at this stage, you own only K50,000 worth of it, hence, your equity

In retrospect, the reality in this case is that equity represents your down payment (i.e., investment). Once you establish this understanding, calculating equity becomes easier, just like knowing the back of your hands. 

To calculate your equity, you simply subtract the principal loan amount (K450,000) from the original price of the property (K500,000). In other words, the resulting amount will always equate to your down payment or investment, which is also known as your equity. 

 

Building equity

Real estate investors, sometimes, set forth additional renovations to the property, apart from the loan and down payment. This increases the worth of the equity which, like a ripple effect, increases the value of the property. 

For example, if you were to invest K10,000 of your own money into renovations, this may well increase the value of your property by, say, K20,000. Therefore, your property is now worth K520,000, your loan remains consistent at K450,000 and the equity is now K70,000 (an additional K20,000)

It is sometimes possible to borrow from your equity, or a re-mortgage, but the drawback is your equity will decrease, while your loan increases.

On the whole, there are other factors as well, besides renovations and home improvements that affect the nature of equity, for better or for worse.

 


Factors exacting an increase on equity

Equity is not a fixed amount that you can easily settle for. Instead, it is fluid in nature, so it’s easily affected by financial situations. To increase the value of your equity, you can do either of the following. But then again, it all comes down to your financial situation:

 

(i) Loan repayment

Every time you offset a mortgage installment, your equity in the house accumulates. This will also encapsulate any tax or insurance payments you offset on behalf of the property. 

Better yet, the more committed you’re in paying off your loan and parallel liabilities, the more your equity grows. 

 

(ii) Pay more than you need to

Say your loan repayment is at a rate of K700 a month. But due to a favorable financial situation on your part, you are able to pay K850 per month, instead. 

So, paying extra in offsetting your loan is an effective way of quickly reducing your loan principal and, in turn, building your equity.

 

(iii) Cash injections

Business wise, cash injection literally means pumping money, stock or debt into a business, in return for a share in the business. In real estate, this will entirely concern your equity and its growth.

Capital injections, as contributions from your family, friends or colleagues into increasing the value of your property also improves the status of your equity.

 

(iv) DIY home improvement projects

Just like being up-to-date with your mortgage repayments, every time you perform a DIY improvement on your home, your equity increases.

The reason being, improvements or renovations usually lead to forced appreciation in the fair market value of the property.

 

(v) Property appreciation

One of the economical aspects of a property is that it appreciates in value. Thus, once your investment property appreciates, it plays to your tunes. 

This means that as the value of your property appreciates, so does your equity.

 

Here’s an illustration:

Noel buys a house at a fair market value of K500,000. His down payment was K50,000. The rest was paid for by the loan at a cost of K450,000. 8 years down, Noel decides to sell his property. He finds that his property is currently worth K650,000. Because of this appreciation, his equity is now worth K200,000 (down payment + appreciation value), including additional costs you’ve paid for the loan during the 8 years. 

Supposedly, say Noel has paid back K30,000 during the past 8 years. His equity would equate to: 

His initial down payment (K50,000) + the appreciation value (K150,000) + the amount of the loan already paid (K30,000). 

Furthermore, regardless of the factors that feed the growth of your equity, it is difficult to determine how much your equity is really worth, until you decide to sell your property, and also having a realtor appraise it. 

 

Factors effecting a decrease in equity

A coin has two sides. A story has two sides. Life is all about good and bad, and as there are factors that help equity increase, there are also factors that lessen its growth.

Consequently, here are four major factors that cause equity to decline:

 

(i) Loan refinancing

Although taking out a new loan to pay off an outstanding loan may seem clever at some point, the process has negative implications on your equity written all over, because you’ll be putting up your equity as guarantee for the new loan.

 

(ii) A crash in real estate market value

The value of your property is vulnerable to changes in the real estate market. If the market experiences a crash at any point in time, it automatically becomes hazardous to your equity as well as your property’s value.

Let’s use the previous example to demonstrate this scenario (where Noel bought the property for K500,000 with a down payment of K50,000). 

Picture this, the market crashed, so the value of Noel’s property is now worth a mere K390,000 (K500,000 - K110,000). Despite his K50,000 in equity, the property’s value decreased by K110,000. 

Nonetheless, Noel still wants to sell the property, because of his loan outstanding. Instead, of being patient, he goes ahead with the sale. In the end, he’s found himself in a ‘negative equity’ position, because of the fact that his property’s value has fallen way below the outstanding balance on the mortgage, which is -K40,000 (K390,000 - K450,000).

A perfect illustration of negative equity at work was the height of the LNG project, back in 2014, where Port Moresby witnessed a huge influx of overseas workers who needed to be accommodated. During that time, the demand for housing was at an all time high than the supply. The immediate impact was a mounting pressure on both the rental and sales markets, causing a significant increase in property values. Unfortunately, this boom was short lived and anyone who had bought a house during that period succumbed to the wrath of negative equity in the years that followed, when they decided to sell their property, as demonstrated by Noel’s example. 

However, It’s not all doom and gloom. Whilst property value can go up  and down over a short period of time, the general consensus is that a property’s value will generally increase in the long term; hence the phrase, “safe as houses”.

 

(iii) Damages to the property

Damages to your property, including by natural disasters and pests, can directly affect your equity, because of the costs you will encumber in fixing them. Unless your property’s insured, you’re bound to spend money on the damages. 

 

(iv) Neglecting maintenance

Ignoring the need for maintenance on your property will play against you. Neglected maintenance is costly and negatively affects your equity. However, the opposite is true in that it helps build your equity.

 

Conclusion

At the end of the day, the privilege of equity rising is that you have a number of options to use the surplus cash that’s generated. Additionally, once the loan is settled in full, you will  be entrusted with the deeds, and the property becomes truly yours. And of particular importance, note that the only way you can know how much your equity is truly worth is when you decide to sell the house.