Under the law, ownership has many aspects, including (but not limited to) possession and use. Though many people "own" their houses and cars, they have not actually paid for them entirely. The word "equity" comes from the Roman goddess of fair trade and honest merchants, Aequitas. It's rooted in the concept of true value. The modern concept of equity describes the true value of an ownership interest.
There are several definitions of equity, depending on the specific context. Generally, equity represents an ownership value in a given property or business. Equity is equal to total market value less any mortgages, debts, liens, liabilities or other encumbrances.
On a company balance sheet, ownership or stockholder equity is the amount contributed by the owner plus or minus any profits or losses of the company. A share of stock is called an equity because its value is based on this calculation. In real estate, a homeowner's equity is whatever is left over after the outstanding mortgage is subtracted from the market value of the property.
As most corporate executives and homeowners know, equity is not just a passive store of value: It can also be tapped and leveraged. Banks sometimes offer lines of credit against the equity in a home, using the home itself as collateral. Publicly traded corporations are those that have sold their equity to the public market to raise capital for business operations.
There are two factors that cause equity to fluctuate. First, the level of debt can be increased by borrowing (which reduces equity) or paid down (which increases it). Second, the market value can change, affecting equity. Ideally, owners like to see the value of their property increase, even if they're not looking to immediately sell, because it raises their equity. When values decline, however, equity does as well, and this can affect an owner's ability to obtain (or cost of obtaining) future loans.
A key metric used when evaluating equity is the loan-to-value ratio, or LTV, which compares the value of your property to the outstanding debt against it. To calculate LTV, divide the debt amount by the market value. The loan-to-value ratio is similar to formulas used by rating agencies to determine individual credit scores. A lender will not approve a mortgage without significant equity in the form of a down payment, keeping the LTV manageably low. If conditions change, resulting in the LTV becoming too high (even above 100 percent if the value falls below the debt amount), the ability to borrow against the property will be impaired.
Joseph Nicholson is an independent analyst whose publishing achievements include a cover feature for "Futures Magazine" and a recurring column in the monthly newsletter of a private mint. He received a Bachelor of Arts in English from the University of Florida and is currently attending law school in San Francisco.