Grove Family Investments

One of the key concepts in real estate investing is equity but it’s more than a concept. Understanding equity and how to predict it in the future is the path to fully understanding how real estate investing builds wealth. Not understanding it is probably costing you hundeds of thousands of dollars. Let’s break it down.

What is Equity?

Equity is the amount of money you would receive if you sold your property after accounting for all outstanding debts and sales costs (e.g. agent commission). Factors that contribute to equity include the market value of your property, any renovations you’ve made, and the amount of debt you’ve paid down over time.

Estimating Equity with the Future Value Equation

To estimate your property’s future equity, you can use a future value equation. Don’t worry, you don’t need to be good at math, there are calculators online that can do the math for you. A future value equation is the equation that calculates compound interest but it can be used to estimate the future value of real estate as well. Here’s how it works:

• If I have a house worth $100 and it increases in value by 10% every year, after 1 year it will be worth $10 more or $110.
• The next year it increases by 10% again, but this time, it’s 10% of $110 so it will be worth $11 more or $121.
• and so on …

The Role of Amortization in Mortgage Loans

Understanding how mortgage loans are structured is crucial to grasping equity. Mortgage loans are typically amortized, meaning your monthly payments are split between paying down the principal and covering the interest. However, this split isn’t even throughout the life of the loan.

Mortgage amortization is front-loaded with interest, meaning that in the early years of your loan, a larger portion of your payment goes toward interest, while a smaller portion goes toward the principal. As time progresses, this trend reverses, with more of your payment going toward reducing the principal balance and less toward interest. Early on, your equity grows more slowly but picks up pace as you pay down more of the principal.

Predicting Loan Balance and Equity

To better understand how your equity will grow over time, you can use an amortization table. This table shows the breakdown of each payment, allowing you to see how much goes toward interest versus principal. By using an amortization table, you can predict your loan balance and estimate your equity at any given point in the future.

Real-Life Case Studies: Applying the Concepts

To bring these concepts to life, let’s look at two case studies.

First, consider a property in Baltimore. I’ll round the numbers for simplicity but it’s a real house I acquired. By applying the future value equation and understanding the amortization schedule, you can estimate how much equity you will build over time. In this case, the investment was $50,000. Using the future value equation and assuming that the market appreciates by 4% annually (the national average since records have been kept) it will be worth $465,000. The tenant is also paying rent which pays down the balance of the underlying mortgage. using the amortization table the balance on the loan will be about $200,000. I will have collected about $50,000 in rent profits. This means the equity in the house plus the rental profits would create a total profit of$315,000 – $50,000 or $265,000. this is a total return on investment of about 500 percent.

Now, let’s compare this real estate investment to an investment in an S&P index fund which is what I would have done with the money If I didn’t put it in this house. using the same feature value equation and assuming 8% annual return I will have about $110,000 in the account for a profit of $60,000.

In other words, if not investing this house would have cost me about $200,000.

How much have you lost by not investing in real estate?

Conclusion

Understanding equity and amortization is crucial for any real estate investor. By mastering these concepts, you can make informed decisions that maximize your returns and build wealth over time. Whether you’re investing in properties like the one above or considering other financial opportunities, a clear grasp of equity will serve as a valuable tool in your investment strategy. If you’d like to learn more or discuss how you can get into these kinds of investments yourself, schedule a time to chat.