When you hear of home equity loans or equity in other forms of property, do your eyes glaze over as you nod and pretend to know what is being said? Do not be embarrassed; many of us were not taught what financial terms meant; therefore, it can not be a big surprise that we do not understand them now.

In simple terms, equity is the value of property after subtracting what is owed from the fair market value; it is kind of like our interest in the property after the mortgage.

For example, if you have a house that is worth (fair market value) $100,000 and a mortgage of $50,000, the equity in the home would be $50,000.

With each payment you make on a mortgage, you reduce the principle amount owed, thus increasing the equity in the home (or your interest). The problem is, early in the mortgage, you are paying primarily interest and little of your payment is actually going toward the principle. Therefore, little equity is built in the property until later in the life of the mortgage when a larger portion of the payment goes toward the principle.

Equity exists in other forms of property as well. A car, for example, also has equity under the right circumstances. However, a car, which typically depreciates rapidly, does not usually have any equity until later in the life of the vehicle. For example, a new car, which costs $20,000, is driven off the car lot and immediately drops in value by roughly one-third. Therefore, although you still owe $20,000 (more with interest), the vehicle is only worth just over $13,000. Because there is no value after the financing or amount owed, there is no equity in the vehicle. Not until the principle is paid down considerably, will the vehicle build any equity.

Understanding Equity