Loan equity is a critical concept in personal finance, especially when it comes to purchasing a home, taking out a business loan, or refinancing an existing loan. In simple terms, equity represents the ownership value in an asset, such as a home or a business, after accounting for any outstanding debts on that asset. Whether you’re buying your first home, applying for a mortgage, or seeking business financing, understanding loan equity and how it affects your borrowing power is essential to making informed decisions.
This article will explore the concept of loan equity, its importance, and how it impacts your ability to borrow money.
What is Loan Equity?
Loan equity refers to the portion of an asset that you truly “own” as a borrower. It is the difference between the market value of an asset and the remaining amount you owe on any loan secured against that asset. In terms of a home, for example, your equity in the home is the difference between the current market value of the property and the amount still owed on your mortgage.
How is Equity Calculated?
Equity is calculated by subtracting the outstanding loan balance from the current market value of the asset.
- Equity Formula:
Equity=Market Value of Asset−Loan Balance\text{Equity} = \text{Market Value of Asset} – \text{Loan Balance}Equity=Market Value of Asset−Loan Balance
If you own a home worth $300,000 and have a remaining mortgage balance of $150,000, your equity in the home is $150,000.
Types of Loan Equity
There are two primary types of equity relevant to loans:
1. Home Equity
In the context of real estate, home equity is the amount of the home’s value that you own outright, without owing any money to the lender. For example, if you purchase a home for $250,000 and have paid off $100,000 of the loan, you have $100,000 in equity in the home.
- Positive Home Equity: This occurs when the value of the home is greater than the outstanding mortgage balance.
- Negative Home Equity: This happens when the outstanding loan balance exceeds the market value of the property, which can occur in declining housing markets.
2. Business Equity
In business financing, equity refers to the portion of the business that is owned outright by the business owner(s). In this case, equity is the value of the business after deducting liabilities from its total assets.
- Owner’s Equity: The owner’s equity in a business is calculated by subtracting business liabilities (debts) from its assets.
- Investor Equity: If investors are involved in the business, their share of the equity is represented by their ownership stake in the company.
The Role of Equity in Borrowing Power
Equity plays a significant role in determining how much money you can borrow. The more equity you have, the greater your borrowing power. Lenders consider equity to assess the risk associated with lending you money.
1. Home Loans and Mortgages
When applying for a mortgage, your home equity is one of the primary factors that determine your borrowing power. Lenders use the concept of Loan-to-Value (LTV) ratio to evaluate the amount of money you can borrow in relation to the value of your property.
Loan-to-Value Ratio (LTV)
LTV is a percentage that compares the loan amount to the appraised value of the property. For example, if you apply for a mortgage loan of $180,000 on a home worth $200,000, your LTV ratio is 90%. Lenders typically prefer lower LTV ratios, as they represent less risk to the lender.
- LTV Formula:
LTV=(Loan AmountAppraised Property Value)×100\text{LTV} = \left( \frac{\text{Loan Amount}}{\text{Appraised Property Value}} \right) \times 100LTV=(Appraised Property ValueLoan Amount​)×100
An LTV ratio of 80% or lower is often considered ideal for traditional mortgages, as it indicates that the borrower has sufficient equity in the property.
How Equity Affects Borrowing Power
- Higher Equity, Lower Risk: The more equity you have in your home, the less risk the lender faces. If your LTV ratio is low, the lender knows that even if property values decline, you are less likely to default on the loan.
- Access to Better Loan Terms: Higher equity may also make it easier to qualify for lower interest rates or other favorable loan terms, such as no PMI (Private Mortgage Insurance) requirements.
2. Home Equity Loans and HELOCs
Once you’ve built up significant equity in your home, you may be able to borrow against that equity through a home equity loan or a home equity line of credit (HELOC).
- Home Equity Loan: This is a second mortgage that allows you to borrow a lump sum of money using your home equity as collateral. The interest rate is typically fixed, and the loan term can range from 5 to 30 years.
- Home Equity Line of Credit (HELOC): A HELOC is a revolving line of credit that allows you to borrow against your home’s equity as needed. The interest rate is typically variable, and you can borrow and repay funds repeatedly over the term of the loan.
Your borrowing limit for both types of loans is often determined by your LTV ratio. The more equity you have, the higher the potential loan amount.
3. Business Loans
In the case of business loans, lenders will evaluate the equity in the business as part of their decision-making process. A business with higher equity is seen as less risky to lenders because it indicates that the owner has invested a significant amount of capital into the company.
How Equity Affects Business Loan Approval
- Stronger Financial Position: A business with substantial equity is more likely to be approved for a loan. This is because equity demonstrates the owner’s commitment to the business and provides a buffer in case the company faces financial difficulties.
- Lower Interest Rates: Lenders may offer lower interest rates to businesses with a higher level of equity, as it lowers the perceived risk of lending.
- Access to Larger Loan Amounts: Companies with more equity are more likely to be approved for larger loan amounts since they have more assets backing the loan.
4. Auto Loans
Equity can also play a role in securing an auto loan. If you’re purchasing a car and you make a down payment, you create equity in the vehicle. The greater your down payment (or trade-in value), the more equity you have in the car, which can reduce the amount you need to borrow.
Equity in a Car Purchase
- Positive Equity: If you have a significant down payment, you will have positive equity in the car from the beginning, which can help lower your monthly payments and potentially get you a better interest rate.
- Negative Equity: If you owe more on a car loan than the vehicle is worth (negative equity), you may struggle to secure a new loan or refinance your current loan.
5. Refinancing and Equity
Equity is also a key factor when refinancing a loan, especially for mortgages and home equity loans. The more equity you have, the more likely it is that you can refinance at better terms, whether that means lower interest rates, reduced monthly payments, or the ability to take out additional cash.
How Refinancing Works
- Mortgage Refinancing: If your home’s value has increased or you’ve paid down your mortgage balance, refinancing your mortgage can help you secure better loan terms. A higher equity ratio may allow you to eliminate PMI or reduce your interest rate.
- Cash-Out Refinancing: With cash-out refinancing, you borrow more than you owe on your mortgage and take the difference in cash. The amount you can borrow depends on the equity you have in the property.
How to Build Loan Equity
Building equity is a long-term process, but it’s essential for maximizing your borrowing power and reducing your financial risk. Here are some strategies to help you build equity:
1. Make Larger Payments
By making larger payments than the required monthly minimum, you can reduce the outstanding loan balance more quickly, thereby increasing your equity in the asset. This applies to mortgages, business loans, and auto loans.
2. Increase the Value of Your Asset
In real estate, increasing the value of your home through renovations, home improvements, or better property maintenance can also increase your equity. This, in turn, can enhance your borrowing power.
3. Paying Down Debt
Paying off other debt can free up more of your income for investing in assets that build equity. Whether it’s paying off credit cards or student loans, reducing debt can provide more financial flexibility.
4. Reinvest Business Profits
For business owners, reinvesting profits into the company rather than taking them out as personal income can help build the business’s equity over time, making it easier to secure financing for future growth.
