Equity

The amount of the home owner's interest in the property. It is the difference between the fair market value of the property and the outstanding mortgages. A home owner's equity increases with each payment of principal in a "blended" payment mortgage (where the same amount is paid each time), even if ever so slightly. A home owner's equity will also increase or decrease based on changes in the fair market value of the property.

The best way to look at equity is to view a house as an elastic pie -one that can expand and shrink. Assume borrowers' house (and therefore the pie) is worth $100,000. If they have financed their house with a $70,000 mortgage, the lender owns the $70,000 piece of the pie, while borrowers' share (their equity) is $30,000. If the house does not change in value, every dollar of principal paid by borrowers would increase their share of the pie while similarly reducing the lender's interest in the property. Principal payments totaling $250 the first year mean borrowers' share of the pie (or their equity in the property) is now $30,250, the lender's share being reduced to $69,750.

Whatever happens to the value of the property affects only borrowers' piece of the pie. A drop in property value to $97,500 means their share of the pie or their equity is now $27,750 ($97,500 less the $69,750 owing to the lender). If the property rises in value to $102,000, borrowers benefit from the $2,000 increase, meaning their equity is now $32,250 ($102,000 less the outstanding mortgage of $69,750).

If borrowers need a $5,000 loan, and have equity of $32,250, they could arrange an "equity loan" for the $5,000. Equity loans are very common for home improvements and renovations, and are nothing more than second mortgages. What borrowers are doing is giving another lender (a second mortgagee) a $5,000 piece of the pie.

If the property is worth $102,000, and the amount of the two mortgages totals $74,750, the equity is reduced to $27,250. Once the $5,000 is repaid, borrowers get that piece of the pie back, and their equity returns to $32,250, assuming nothing else has changed.

The priority of claims can easily be illustrated by imagining a totem pole worth $102,000. The first mortgagee is at the top, with a share of $69,750. Next comes the lender with the $5,000 second mortgage. At the bottom of the totem pole are borrowers with the remaining share of $27,250.

Remember two points: (1) only the home owner's equity is affected by changes in the value of the house and (2) the faster the principal is repaid to the lender, the faster the home owner's equity increases.

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