Back to Basics: Asset, Liability, Equity

Alright, let’s talk about the concepts of Asset, Liability, Equity.

We start off with this accounting formula:

Asset = Liability + Equity

To give these terms simple definitions:

Asset: What you control
Liability: How much of that control is not actually yours (yet…)
Equity: How much of that control is yours

Let’s have a look at this example here:

You bought a house worth $100,000 and paid a 10% down payment for it ($10,000). The rest of the amount is financed by a bank.

So, here’s the situation:

The $100,000 house = Your ASSET (You control this)
The $90,000 loan = Your LIABILITY (Proportion of the bank’s loan)
The $10,000 down payment = Your EQUITY (Proportion of what is actually yours)

That’s also why, when you calculate your net worth, if you have a 1-million-dollar house in your portfolio, sometimes, it doesn’t mean that you are worth $1,000,000. If your equity is only $200,000 and the other $800,000 is from the bank’s loan, that means your net worth is only $200,000.

Let’s have a look at another concept related to investment properties. The concept is “locked up equity in investment properties.”

Generally, the price of houses increase over time. Going back to the first example of the $100,000 house, let’s assume this:

1. The price of the house has increased by 10% after one year
2. The amount of loan paid after one year is $5,000

So,

ASSET = $110,000 (after an increase of 10%)
LIABILITY = $85,000 (minus the $5,000 paid)
EQUITY = $10,000(down payment) + $5,000(loan paid off) + $10,000(increase of house price)

As you can see here, your equity has increased from $10,000 to $25,000. That $25,000 is locked up with the house. You can’t withdraw it easily like cash from your savings account, thus why it is called locked up equity. One way to ‘release’ this equity, so to speak, is by refinancing the property.

What is that you ask? Basically, you tell the bank of the new amount of equity in your house (through proper procedure of course), and the bank transfers the amount you require from EQUITY to LIABILITY, and now you can withdraw that money. Of course, this will add to your LIABILITY section and decrease your EQUITY section. In other words, you are borrowing more money from the bank and use that NEW EQUITY as a collateral.

Have a look at the diagram below:

Equity Diagram

Why would people refinance then? Well, normally, people do that so that they can use that “locked up” money to purchase other investment properties. Then, the following year, as the price of that first house and the newly-purchased house increase, more EQUITY will be available. Now, they might want to withdraw that further EQUITY and purchase more properties.

In a way, it’s like rearing goats. You first buy father goat and mother goat. Then they procreate, thus producing baby goats. These baby goats grow up, then father goat and mother goat procreate again, and baby goats also procreate, producing more goats. You get the picture.

In this case, you’re trying to breed properties.

Alright, till next post.

P.S. This post is not a specific advice or recommendation to do anything. Consult your financial advisers before investing your money. Refer to my DISCLAIMER.

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About nadlique

This blog is about the journey of a 28-year-old Malaysian towards financial freedom. This blog was started back when the blogger was 21 years old. However, his journey towards financial freedom had begun way before that. Materials such as investing, business, entrepreneurship, equities, and real estate are presented. The author also posts his thoughts and observations on life in general.

Comments

  1. i still dont get the picture, the part where the mother and the father of the goat making a family.:P

  2. a start at property investment? or have u started already? ๐Ÿ™‚

  3. Wyn: Hehe. Maybe I should have drawn a diagram to illustrate that situation better huh? LOL ๐Ÿ˜‰

    Ici: Not yet. Still saving money for my first investment property. I’m getting there ๐Ÿ™‚

  4. Then you have the Loan-on-equity (shall we call this a “second mortgage”?) to make payments on; and you have the new property mortgage. Understanding what you actually own gets complicated. Perhaps there is some computer software to help keep track?

  5. Yup, your monthly loan repayments shall increase. The individual needs to find ways to cope with this, or find a highly POSITIVE cash flow property to offset the higher repayments.

    I’m sure there are softwares to keep track of this. Or even, a simple spreadsheet might be of some help.

    Usually, for those who have significant amount of properties, they hire people to manage those properties.

  6. While we’re on this subject, I thought I might share something.

    I read this book recently and the author touched on this locked up equity subject. What I thought was rather peculiar is that, apart from using that equity to purchase another property, he also mentioned of using that equity to fund lifestyle, i.e. take up debt to go on holidays and etc. Hmmm… I certainly wouldn’t do that. Though the interest rate might be lower than by using credit cards, I still wouldn’t feel comfortable taking up bad debts.

  7. What I mean is that your equity in the first property is diluted when you take a second mortgage on it. In addition, the calculation of equity for the first property is made more complicated by having a certain equity growth scheme in the first mortgage and another equity growth in the second mortgage. There are probably some conventional accounting techniques to make this understandable, but I don’t know them.

    Separately, I think what we have here is the first step to leverage. You are taking a loan on an unrealized gain in order to enable the purchase of another property. If the market value of the first property should decrease, then the unrealized gain evaporates, and the mortgage holder might call in the second mortgage. All depends on the terms of the loan, of course. This could be inconvenient if all funds are fully committed so that you have no way to meet the call.

  8. Just to add to that, like the recent subprime crisis, house prices fell by 48% (or perhaps more?). Home owners will face a huge problem if they adopt the approach of loan-on-equity.

    It’s like a pyramid scheme don’t you think? Every properties are related to each other, one falls, and the rest will collapse.

  9. What would you do if you have quarter million of cash in your hand Nadlique? Where would the money go?

  10. If I were a Bumi and not constrained by Islamic investment rules, then my first step would be to fill up ASB to the 200,000 maximum. Absent ASB or some equivalent, I would apply the rule of (100 minus age) to determine the amount to put into a fixed income investment. For Nadlique I think this means 100 – 21 = 79; so 21% fixed and 79% in shares. Let’s make that 20% and 80% for easy arithmetic. At the age of 21 I would be rather aggressive on the shares (or actually, in mutual funds). I would put 20% in small cap, 20% in mid cap, 20% in large cap, and 20% in foreign markets.

    Now why did I want to fill up ASB? Because it has the characteristics of both fixed income (no losses) and stock investment (potential for high gain). On top of that, it’s tax-free!

    Disclaimer

  11. assuming that your asb is already at maximum limit, and still have about 250G in excess what would you guys do?

  12. Your ASB has 200,000, and you still have 250,000? All the stars, the sun and the moon are in a straight line!

  13. If I have $250,000, the first thing that I’m going to do is to harbour it in a trust with my company as the trustee. This is to avoid any prying eyes from having any funny ideas. Through that trust, of course, I’ll be investing the quarter of million dollars.

    The question of where, depends on my age. If I was to receive the money today, of course a huge portion will be invested in business, and other aggressive assets.

    If I was to receive it much later in life, perhaps a majority of that will be invested in conservative to moderate risk assets but still within the realms of business, shares, properties, unit trusts, and bonds.

    But that’s just me.

    If you have a huge amount of money, your best bet is to actually consult a financial adviser. Then only you can explain to him about yourself and he’ll hook you up with appropriate investment vehicles.

    Disclaimer

  14. there’s also the inflation part to take into consideration…

  15. True enough Sting ๐Ÿ™‚

  16. I recently got a bookkeeping job for a real estate company and I was recently asked by one of the owners why would Assets = liabilities + equity when a liability is something that you owe? I hope I’m posing the question correctly. I know that this is a general accounting equation but I want to make sure I can explain this to the partner so that he understands and I get a better understanding. Any information you provide would be greatly appreciated. The confusion I have is because the reverse Liabilities + Equity = Assets doesn’t make much sense to me.

Trackbacks

  1. […] Properties better than Shares? – Property Investing: Battle of Conscience – Risk Tolerance Level – Back to Basics: Asset, Liability, Equity – Risk Tolerance Level: Part […]

  2. […] Back to Basics: Asset, Liability, Equity – Why Everyone Should be Wealthy – Why Not Everyone Can be Wealthy – Passive Income Exceeding […]

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