A bundle of rights that the owner of a property has before the deed is transferred to another. The person who owns an equity in a property is called an equity holder.
The term “equity” is most commonly used when discussing mortgages, which are one type of debt instrument that can have an equity component. A mortgage can be thought of as a loan taken out against one’s own home. The equity component of this loan is represented by the value of the home, which means that a portion of the value provided by a mortgage is taken as equity.
In mortgage lending, an investor uses funds received from institutional or private sources to purchase securities. These securities are then resold to bondholders or other institutional investors. The debt instrument that results from this transaction is known as a “mortgage-backed security.” The original sponsor of the mortgage-backed security then has an interest in the securities’ increased value, because it receives a portion of the amount owed on certain performance benchmarks (such as interest rates or principal balances).
In the case of a mortgage, the equity component is often the value of the home. This means that the borrower’s repayment obligations are met by a portion of their home’s value. The borrower’s repayment obligations are considered “risk-free”, because the borrower can sell their property at any time. This secures the performance benchmarks to be met without risking more than what was originally invested in mortgage debt (the amount borrowed from a bank).
Other types of mortgages have additional equity components, such as mortgages for commercial real estate and industrial revenue bonds, which have special-purpose revenue bonds. These two types of mortgage investments are taken out against commercial and industrial property or projects instead of residential property.
The equity component of a mortgage is similar to the owner’s interest in a privately held corporation. The equity holder has the right to sell their stock in order to gain liquidity, if they wish. A corporation is a special type of entity that is owned by its shareholders, who have the right to any dividend, and also control major decisions (such as the sale of subsidiaries, etc.) made within the entity. Unlike corporations, which are authorized by state law with certain requirements that must be met in order to conduct business (for example, minimum capital requirements), mortgages can be issued by any willing lender.
Mortgage holders are also referred to as owners or equity holders. The term “equity holder” was used to differentiate between different mortgage-backed securities, as they differ in the extent of their equity components. Equity in a residential mortgage-backed security is represented by the value of a home, while equity in a commercial mortgage-backed security is represented by revenue bonds that secure real estate revenue. An equity holder has ownership in a property and has the right to any returns from that property that may be paid out in the future.
In many cases, only part of an owner’s equity may be required for full repayment of an outstanding mortgage debt. This is similar to the dividend payment made by corporations to their shareholders. A dividend can be distributed in such a way so as to reward shareholders, who then have an equity interest in the company.
The percentage of equity that an owner has in a property is known as “equity exposure.” In most cases, equity exposure is not equal to the amount owed to a lender. This is because the borrower’s repayment obligations are partially met by the value of their property. The borrower’s repayment obligations are considered “risk-free”, because they can sell their property at any time for full payment on outstanding debt.
Most mortgages have more than one category of debt, which are used for different purposes. The two main categories of debt in residential mortgages are the principal (or face) and the interest portions of the loan, as well as a balloon payment. The principal portion of a mortgage is the known, outstanding amount owed on the loan. It usually represents a percentage of the appraised value of the property or project that was financed, although it may be lower. For example, if an investor purchases $100 million in mortgage-backed securities with a principal value of $100 million, then its total debt will be $100 million. The balance on this security will be equal to 40% ($80 million) in principle ($20 million).
The interest rate is the fee paid by the borrower in order to use the money that was provided by a mortgage lender. Interest can be paid on the principal portion of the debt, just on the interest component, or any combination of those two possibilities. The interest rate may be fixed (i.e., does not change over time) or adjustable (i.e., changes over time). In many cases, mortgages contain both fixed and adjustable components.
The balloon payment is a single lump-sum repayment made at some point in time after all other payments have been made. A balloon payment usually has a much higher value than other payments throughout an investment’s life and often constitutes a substantial part of an investment’s balance.