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How Does Equity Work | A Guide for 2022
Knowing how to use equity early could be the difference between retiring at 65 instead of 45. Sounds interesting right? But how does equity work? This guide will provide you will all the information you need to understand equity so you can make smarter financial decisions.
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Did you know that only 30% of Gen Zers own some kind of equity? That’s far from enough.
It’s more important than ever to understand equity. With the world economy in a state of flux, knowing how to use equity early could be the difference between retiring at 65 instead of 45.
Sound interesting? Good. This guide will provide you with all the information you need to understand equity and make smart financial decisions for your future!
What is Equity?
Equity is a term used in a variety of different contexts. At its core, equity refers to the value of an ownership stake in a company, enterprise, or property. For example, if you still pay for your ex’s Netflix account, you own all the equity in that account. (Small victories!)
When you own equity in a company, you are entitled to a portion of the profits and assets that the company generates.
There are two primary types of shareholder equity: common and preferred.
- Common equity is the most basic form and is granted to shareholders on a pro-rata basis. Everyone who owns common stock receives an equal share of any profits generated by the company. If you $GME on Robinhood, you have common equity.
- Preferred equity is more complex and usually comes with preferential rights. Examples include receiving dividends before common stockholders or having the first claim on assets if the company is liquidated. Typically, investment firms and company executives have preferred equity.
Suppose you want to see the current market value of a company (AKA market capitalization). In that case, you just have to multiply the share price by the total number of shares trading. On paper, the company’s equity value is also straightforward: it’s the company’s assets minus their liabilities (more on this later).
AKA equity in a business, private equity is very similar to shareholder equity. Instead of owning part of a publicly-traded company, you own part of a private firm.
Private equity investors are usually big venture capital firms, but that doesn’t mean you can’t join the party. As far as investments go, returns on private equity often beat out other asset classes (like the S&P 500, real estate, etc.)
Owner’s equity is the value of a business that belongs to its owners. This is the most straightforward form of equity because it’s just the difference between your assets and liabilities.
- Assets are things that you own, such as cash in a savings account or the value of your home. Intangible assets like patents, content, and love are also included. (Maybe not that last one).
- Owners owe liabilities to other parties (aka creditors), like credit card debt or student loans.
For example: You own a roller derby business (which is SO cool) worth $500,000 with an outstanding loan balance of $200,000 liabilities. Your owner’s equity in that business would be $300,000 ($500k – 200k = 300K).
In other words: Owner’s Equity = Assets – Liabilities.
When you buy a house, you take out a loan to cover the purchase price. Then you’ll make a monthly mortgage payment until the debt is paid off — you should probably have stopped paying for your ex’s Netflix by now.
Your equity increases over time as you make more payments to pay off the principal balance of your mortgage. It can also jump when the value of your home rises. This could happen if:
- The population rises, so demand for homes increases
- Mortgage loan rates rise, so fewer people want to make mortgage payments
- You ask the real estate market really nicely
(Two truths, one lie).
To calculate how much equity you have in your home, find the difference between:
- The amount owing on your mortgage.
- Your home’s current value.
For example, if you have $200,000 left in the principal on your mortgage, but your home is worth $350,000, your home equity value is $150,000.
How to Use Equity to Grow Wealth
You can use equity to make money in a lot of different ways. Let’s go a bit deeper into two strategies for building wealth with equity:
Earning dividends from a company’s shareholder equity.
This is probably the most straightforward way of making money via equity. Many publicly traded companies will pay out a small portion of their profits to their shareholders — these are called dividends.
Here are some of the top dividend-paying stocks:
(Remember to do your research into a company’s finances before you invest!)
You probably don’t spend your weekends digging through corporate financial data. (No judgment if you do!) Still, having some investments in the stock market is a wise way to build your financial future. Looking at a company’s balance sheet can help you understand its financial performance — that way, you’ll make a more thoughtful investment decision.
Tapping into your home equity to finance a new purchase.
Let’s say you asked the market really nicely, and the value of your home skyrocketed. You have $75,000 in equity — congrats! But to cash out, you’d have to sell your home, right? Not necessarily. To tap into your home equity (aka ‘borrowing against it’), you have a few options:
- A home equity line of credit. This is sort of like a credit card where the balance is your home equity. You should use this if you have some flexibility in how much cash you need.
- A home equity loan. This is a loan you get all at once. It’s ideal when you know exactly how much money you’ll need.
If you ever hear anybody talking about taking out a second mortgage, this is what they’re talking about.
Now, why would you borrow against your home equity? There are several reasons:
- Financing a down payment on a new home.
- Paying for higher education.
- Capital start-up for a new business.
- An unforgettable weekend in Cancun. (Doable, not recommended)
- Betting it all on black in Vegas, baby! (Also, very much not recommended)
At the end of the day, it’s entirely up to you — just remember that this is money you have to pay back. You can be sued or even have your home seized if you default on your loan. Make sure you talk to a financial advisor before making any big decisions!
Start Using Equity to Build Your Future Today
Using equity might seem daunting, but understanding what it is and how you can leverage it in your life will help you financially in the long run. The ability to build wealth through equity is just one more tool to keep in your money-making toolbox — along with budgeting skills and understanding credit!
Equity might be a confusing concept now, but understanding it will become second nature with practice (and the right tools).
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Frequently Asked Questions (FAQs)
What does equity mean for dummies?
Equity is the value of your ownership in a company or property. It’s calculated by subtracting any money you still owe on a mortgage or loan from the current market value of the home or company.
How can I use equity to make money?
You can start a new business, invest in higher education, buy into a venture, or earn from dividends. Equity can be a powerful tool for building long-term wealth.
How do you calculate your total net worth?
Your net worth is calculated by subtracting all debts from total assets — essentially what you’d have leftover if you sold everything at once.
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