In an investment context, equity refers to your ownership interest in an asset. Most people associate the term with home ownership and real estate. Equity is the amount you get to keep after you pay off all the loans associated with a piece of property, and pay off anyone else with a lien or ownership claim on the property. The same concept can apply to any other asset.
Definition of Equity
Your equity in an asset or property is equal to the market value of the property or asset, minus any amount you owe on that same asset. For example, if you own a company with assets worth $500,000, but you also have an outstanding loan balance of $300,000, or you have issued bonds worth $300,000, then your equity in the company is $200,000. If you jointly own the company equally with another stockholder or partner, your equity in the company is $100,000. You have a 50-percent equity interest in the company.
The concept of equity is closely related to the concept of book value. A company's book value is the total value of all its assets, minus its total liabilities. The book value, theoretically, is equal to the shareholders' equity in a company.
Equity and Loan-to-Value Ratios
The concept of equity is extremely important in real estate. If you have at least 20-percent equity in a personal residence for example -- a loan-to-value ratio of 80 percent or less -- you can normally avoid paying private mortgage insurance premiums, commonly known as PMI. This can save you hundreds per month. To avoid PMI, maximize your equity in the home by paying down your mortgage balance, making renovations or repairs to increase the home's market value, or coming up with a 20-percent down payment.
If you owe more on an asset than its market value, you have what analysts call "negative equity." That normally means you will have to come up with cash from somewhere else to pay off debts when you sell the asset. The purchase price of the asset won't cover the outstanding debt. This is also referred to as "being upside down" on loans for such assets as a car or home.
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