Meanings of home equity
In finance, the word equity means at least two different things. Choosing the wrong sense of the word can yield nonsensical results.
Accounting
The most basic accounting definition is that equity is the monetary value which equals assets minus liabilities. For example, if you own a house that’s worth $1 000 000 but have an $800 000 mortgage on it, then your equity is $200 000.
In this sense, as you pay down the principal of your mortgage, your equity increases (assuming that the market value of the home remains unchanged). This is commonly referred to as “building equity in your home” through the process of paying the mortgage.
Ownership
In the accounting sense, each business has owner’s equity (or shareholders’ equity for a corporation), defined in the same way – the hypothetical remaining value after all assets are sold for cash and all liabilities are paid off.
But far more often, we talk about someone’s equity in a company as a percentage of ownership. For example, if Alex has 10% equity in Acme Inc., then Alex is entitled to 10% of the proceeds if Acme gets liquidated.
Equity in this sense is bought, sold, and traded in the form of stock shares. For example, a company can raise money by issuing new shares, thus giving away equity while receiving cash. A company can give stocks to an employee as payment for labor. A shareholder can trade shares on the secondary market with other participants without actively involving the underlying company.
Equity as a stake in the ownership of a business is closely related to voting rights. The simplest way to set up a company is to tie equity rights directly to voting rights – so someone who owns 1% of the equity value of the company also has 1% of the votes. If different share classes are set up to have different voting rights, then the shares trade at different values. Equity rights are concerned with the current and future monetary value of the company, while voting rights are concerned with influencing the direction of the company in the future.
Confusion
Looking at home equity like a business though, when you buy a home, you have 100% equity and voting rights in the home, and the bank has 0% equity. If your home’s value increases, then at the time of sale, you retain 100% of the profit and the bank doesn’t earn anything extra; you still owe exactly the amount of the mortgage and nothing more. Paying the mortgage doesn’t “build equity” in your home in this sense because you already started with 100%.
In terms of voting rights, the bank cannot force or prevent the sale of your home as long as you pay the mortgage as agreed. But if you don’t pay the mortgage, then the bank can seize ownership of the home as per the contractual terms, sell the home, pay off the mortgage, and pay you the remainder if the sale yielded more money than the amount owed. In this sense, having a home mortgage is like a company issuing a bond – the bondholder is only entitled to a pre-defined steady stream of payments, but is not entitled to the equity of the counterparty, unless the counterparty fails to pay, in which case the counterparty is bankrupt and the bondholder seizes control of the counterparty’s assets and voting rights.
Although the vast majority of mortgages have 100% of the control and profit placed in the homeowner’s hands, there are cases where another party does have a stake in the home’s equity. For example in , the Canadian federal government introduced a scheme where they pay for up to 10% of the purchase price of a home, with the understanding that you have to pay them that share upon selling the home. To illustrate, say that in you buy a condominium unit for $500 000, so you are responsible for paying $450 000 (which you source through cash, mortgage, family, etc.), and the government pays $50 000 and owns 10% of the value of your home. Later, you sell in for $800 000, so you receive $720 000 (where some of that might need to pay off your remaining mortgage) and the government receives $80 000.