What is equity?

Equity varies depending on the context that you are looking at it from.  From a financial perspective, equity represents ownership and an example of this is a stock.  Equity from this perspective is represented by ownership in any asset after any of the debts that are related to that asset are paid off.  An example of a share of equity in a corporation would be if a publicly owned company's ownership is split into 100 shares and you own 5 of them. Then you own 5% of the entire company.  The more equity that you have in an organization, the more you physically own in that company and some companies will even allow you to have a say in how that company runs its business.  This is very important because once you have equity in a company you own it, therefore if something great happens to the company then you actually get a financial stake in it and can earn money; however, if something goes wrong then you can also lose money.
There are three basic types of equity.  The first is common stock which represents ownership in a corporation as the example above shows.  The second example of equity is preferred shares which are stocks in a company that have a dividend and therefore a claim on income to the stockholder that will be paid out on a regular basis.  The last example of equity is warrants which are usually added to a corporate bond or preferred stock.
Equity is ultimately important because it represents ownership.  When you own something that becomes very important to you.  When you have a stake of ownership in a powerful corporation, you are investing money in that company because you have a belief in them.  Therefore, you want that company to do well and as a result of that company performing well, you will receive money for investing.  Equity is important because of the potential profitability as well as the potential losses that could result.

Equity, where finances are concerned, most often deals with homeownership.  Essentially, equity represents your ownership in a home that you purchase with a mortgage.

How Equity Works

Since most people can't afford to buy a home outright with cash they need to turn to a lender for a loan.  Once the borrower is accepted, the lender provides the loan for the house, called a mortgage.  The homebuyer then repays the lender over time.

As long as the homebuyer owes the lender money on the mortgage, the lender can repossess the home.  Over time, as the buyer makes payments on the mortgage, he or she starts to build equity or ownership in the home.

Another way to express equity is as the difference between what your home is worth, and what you still owe on the mortgage. As your home increases in value, you see more equity.  If
your home is worth $200,000, and you still owe $130,000 on your mortgage, the
equity in your home is $200,000 - $130,000, or $70,000.

Equity is expressed as a percentage in many cases. In the example above, you have $70,000 equity in
your home, which is 35% of $200,000.  Over time, you can eventually build up
enough equity to completely own your home, meaning you have 100% equity, and
the bank no longer has claim to ownership in your house.

The flip side is that you can also have negative equity in your home. This is when you owe more than
your home is worth. This can happen if home values drop. If you owe $180,000 on
your home, but it has dropped in value to $160,000, you have $20,000 in negative
equity.

Using the Equity in
Your Home

As you build up
ownership in your home, you can use your equity as collateral for financing. If
you have $70,000 equity in your home, you might be able to borrow $40,000
against that ownership. You can make home improvements, pay off debt, or do
something else with the money. If you miss payments, though, the lender can
repossess your house, because now the home equity lender has ownership in your
home, and your own equity has been reduced to $30,000, or 15% (using the
$200,000 example above).

Equity is most
important when you sell your home. After you sell your home and pay off your
mortgage, whatever money you have left will be equal to the equity you had in
the house. If you've managed to build up a large amount of equity during the
time you owned the home, then you'll have a large amount of money ready to use
as your next down payment or to simply keep for yourself.

Hi Sarah--

There are a couple of uses of the term equity when you're talking about personal finance. One is the term that Miranda described, which is, simply put, the difference between what your home will sell for minus closing costs and commissions and the amount of money that you owe on any mortgages that you might have on that house.

There's another definition of equity, which has to do with ownership of companies. When you invest in the stock market, either through the purchase of stocks or through the purchase of mutual funds, you are buying a very, very (very) small
fractional ownership of the company. That is called equity.

There are two ways that companies can raise money from external sources. They can either go out and borrow money from banks or other lenders, or from the public markets in the form of money or they can sell shares of the company to people. These shares of the company usually represent a microscopic percentage of the overall ownership of the company. That's equity.

So, next time you see a talking head on CNBC discussing equities, you know that the person is discussing stocks in the stock market.