Mortgage lenders and brokers often use terms that mean something different in mortgage lending than in other endeavours.
Interest – One of the most misunderstood term in mortgage lending. Interest is usually thought of as the ‘cost of borrowing’. It is not that simple, interest is also the description of other participating shares. A husband and wife may have Joint Interest With Right of Survivor-ship on title to a property. And I won’t even begin to describe the multifarious ways the mortgage interest is calculated! (Maybe in a future blog I will try to untangle this.)
Leverage – What is financial leverage?
Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known as trading on equity. Below are two examples to illustrate the use of financial leverage, or simply leverage.
Sue uses $400,000 of her cash and borrows $800,000 to purchase 120 acres of land having a total cost of $1,200,000. Sue is using financial leverage. Sue is controlling $1,200,000 worth of land using only $400,000 of her own money.
If the properties owned by John and Sue increase in value by 25% and are then sold, John will have a $100,000 gain on his $400,000 investment, a 25% return. Sue’s land will sell for $1,500,000 and will result in a gain of $300,000. Sue’s $300,000 gain on her $400,000 investment results in Sue having a 75% return. When assets increase in value leverage works well.
When assets decline in value the use of leverage works against you. Let’s assume that the properties owned by John and Sue decrease in value by 10% from their cost and are then sold. John will have a loss of $40,000 on his $400,000 investment—a loss of 10% on John’s investment. Sue will have a loss of $120,000 ($1,200,000 X 10%) on her $400,000 investment. This is a loss of 30% ($120,000 divided by $400,000) on Sue’s investment.
Equity = Assets – Liabilities
Yet, because of the variety of types of assets that exist, this simple definition can have somewhat different meanings when referring to different kinds of assets. The following are more specific definitions for the various forms of equity:
– A stock or any other security representing an ownership interest. This may be in a private company (not publicly traded), in which case it is called private equity.
– On a company’s balance sheet, the amount of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses). Also referred to as shareholders’ equity.
– In the context of margin trading, the value of securities in a margin account minus what has been borrowed from the brokerage.
– In the context of real estate, the difference between the current fair market value of the property and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying off the mortgage. Also referred to as “real property value.”
– In terms of investment strategies, equity (shares) is one of the principal asset classes. The other two are fixed-income (bonds) and cash/cash-equivalents. These are used in asset allocation planning to structure a desired risk and return profile for an investor’s portfolio.
– When a business goes bankrupt and has to liquidate, the amount of money remaining (if any) after the business repays its creditors. This is most often called “ownership equity” but is also referred to as risk capital or “liable capital.”
Equity’s meaning depends very much on the context. In finance in general, you can think of equity as one’s ownership in any asset after all debts associated with that asset are paid off. For example, a house with no outstanding debt is considered entirely the owner’s equity because he or she can readily sell the item for cash, with no debt standing between the owner and the sale. Stocks are equity because they represent ownership in a company, though ownership of shares in a publicly traded company generally does not come with accompanying liabilities.
Yet, in spite of what seems like substantial differences, these variants of equity all share the common thread that equity is the value of an asset after deducting the value of liabilities. One could determine the equity of a property by determining its market value and deducting liabilities (factoring in any sales commission, early payment penalties, and outstanding property taxes) .
Closing costs are mortgage fees associated with loan generation, escrow payments, title insurance and other third-party fees, and some may shared by both the buyer and the seller. Title insurance protects both the buyer and seller from potential defects in the property’s title and pays attorneys and lawyers to fix any problems before the transaction is complete.