Equity is the key to building wealth through property investment.
Simply put, home equity is the portion of your property that you fully own. Most people require a mortgage to buy a property which means a bank or finance institution will lend most of the amount required to buy the property and you would fund the remainder with a deposit.
So if the bank loans you 90% for a property you want to purchase for $100,000 they will fund $90,000 and you will fund the other $10,000…
Therefore your equity is the $10,000 which is the value of the asset ($100,000) minus the debt on it ($90,000).
It’s pretty simple once you get your head around it!
The Power of Equity
In the above example, let’s say that your property which you bought for $100,000 goes up 10% and is now worth $110,000. This means your equity has also increased by $10,000 (because the bank does not get a share of your capital gains of course).
It may not seem such a great gain at first glance, but when you compare this gain with your original investment:
You started with $10,000
Your property went up $10,000 which are your investment returns.
You now have $20,000 equity which represents a 100% return on your original investment (remember the bank financed most of the purchase!).
Now is 100% return in one year a good investment? We think so! This shows the power of using finance to increase the rate of equity growth.
If you had funded the whole cost of the property yourself, you would have only made the 10% return.
It Gets Better
Assuming that our property goes up 10% per year (which is achievable), in the second year when the property value goes up by 10% again.
The property is now worth $110,000 x 110% = $121,000.
Do you know how much our equity is now? That’s right, $121,000 – $90,000 = $31,000,
Your original $10,000 is now worth $31,000 which is a 310% return in 2 years!!
This is what happens when we take compound growth into account. Compound growth means that even though the return per year remains constant (10%) in this example, the actual amount the property goes up by, increases every year!
Check out the progression at 10% per annum:
Purchase Value $100,000
Year 1 Value $110,000 increase of $10,000
Year 2 Value $121,000 increase of $11,000
Year 3 Value $133,100 increase of $12,100
Year 4 Value $146,410 increase of $13,310
Year 5 Value $161,051 increase of $14,641
And so on…
And after 5 years, you now have $71,051 in equity which is a 710% return on your original $10,000.
So by combining the use of debt in order to leverage your equity added with the natural law of compound growth, you really can make great returns with property investing.