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How home loans affect equity

Real estate prices go through ups and downs in every market, and these changes can affect the equity you have in your home. Join Sal Khan of Khan Academy as he uses a personal balance sheet to show what can happen to your home equity when market prices change and why a down payment is important.

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Welcome back. Where we left off in the last video, I had just purchased a million dollar house. To do it, I went to the bank, and I said, "Bank, can you give me $750,000?" And they said, "Sure, Sal. You have an excellent credit rating, and you look like an all-round great guy, so we'll give you $750,000" So I took that $750,000, and the $250,000 that I had saved up through a lifetime of hard work, and I went and I bought that house. So, after that transaction, this is what my personal, well, this might not involve everything, but this could be my personal balance sheet, but it looks like my whole world is this house which in a lot of cases it is for a lot of people.

So, in this situation, what are my assets? I have a million dollar house. On my balance sheet, I have one asset in the world. I guess you can't quantify charisma and good looks, so the only real tangible asset I have is a million dollar house. – And what are my liabilities? Well, I owe $750,000 to the bank, and you shouldn't view this as a formula. It should start to make a little bit of intuitive sense that assets are equal to liability plus equity, or the other way to view it is asset minus liabilities is equal to equity, right, to subtract the liabilities from both sides.

And you know that, well, if I have $1 million of assets, I owe $750,000. If I were to resolve everything, what I'd have left over at the end is $250,000, and I could make that happen. I could sell the house for $1 million, hopefully, and then pay the bank back, and then I would have $250,000 left. So that's what equity is, just what you have left after you resolve everything, and this makes sense to you. If you think about all of the things you own minus all the things you owe to other people, equity is what's left over, or that could be owner's equity.

So now let's play with some scenarios of what happens maybe when the value, the market value of the house changes. Oh, and one important thing to note. This bank, they're not just going to give me $750,000 just to do anything with it. They're not just going to say, "Hey, Sal, here's $750,000. I know you'll pay it back to me but you can go gamble it in Monaco." They want to know that they have a good chance of getting at least the money that they give – the loan amount, and that's often referred to as the principal – they want to know that they're going to be able to get that principal back one day.

So what they say is, "Sal, we're only going to give you this loan, but this loan has to be backed or it has to be collateralized by some asset." So what I say is, "Okay, well you know I'm taking this loan out to buy a house, this million dollar house. If for whatever reason, I lose my job or I disappear somehow or whatever happens, if I can't pay you the $750,000, you get the house. You'll get this million dollar house," and right now that looks like a pretty good deal to the bank, right? They almost hope that I'll default because they gave me $750,000. If after a day, I just say, "You know what, bank? I can't pay this loan." I don't have the income or I lose my job, I can't afford the mortgage, they get a million dollar house. Overnight they would have made $250,000, right? They would essentially have gotten all my equity for free.

So in that situation, the bank works out pretty good, and that's why they make sure that there's something that they can grab on to if you can't pay the loan. And that's why back in the good old days – and I think the good old days are going to come back again, and I think they already are – that the bank wants you to put some down payment in a house because there's a situation where let's say that I do this, I borrow the money and I buy the house, and I lose my job or whatever, I just drink away all my money, whatever the case may be, and so the bank, they foreclose. Foreclose means that Sal isn't paying his debt, so we're going to take the collateral back that he gave for the loan. So in that situation, the bank says, "Sal can't pay. We're taking that house."

Well, when they take that house, there's a situation where, you know, maybe they're not going to get a million dollars for that house. They don't want to sit and wait for months and months and months while a real estate agent tries to sell it, so the bank might just auction off the house, and when it auctions off the house, actually I think there are laws that it can't get more than the mortgage, or anything more than the mortgage it gets, it actually has to pay taxes, but we won't get into all that. But it'll auction off the house, and maybe it can only auction off the house for $800,000, right, so the million dollar asset would really become an $800,000 asset, and so the bank keeps this equity cushion, that if they loan $750,000 for a million dollar house and then the million dollar house only sells for 800, the bank still gets all of their money back.

That's why, in the good old days, the banks want you to put 20% or 25% down because they know, even if the value of the house drops by 20% or 25%, it'll all come from your equity, and maybe I should draw a diagram to see that situation. Let's say that, for whatever reason, I have to sell this house in a fire sale, or let's say I can't sell the house and the bank is forcing me to liquidate my asset. The bank says, "Well, then I want that house back." Well, actually that's not a good situation because the bank will just, I'll just get wiped out.

Let's just do the situation where let's say a neighbour's house that is identical, an identical neighbour's house sells for $800,000. So in that situation, if I want to be honest with myself and if I want to be honest with the balance sheet, and actual real companies have to do this, I'll say, "You know what, this asset, I have to revalue it. I cannot in all honesty say that this is now worth, that this is a one million dollar asset. So I would revalue the asset, and this is actually called marking to market. You've probably heard this concept.

Marking to market means I have an asset, and every now and then, maybe every few months, every quarter, a quarter's just a fourth of a year, I have to figure out what that asset is worth, and the best way to figure out what that asset is worth is to see what identical assets like that are going for in the market. Very few houses are completely identical – well, there are in kind of a few suburbs – but very few houses are completely identical, but let's just say that I know for a fact that an identical house just sold for $800,000.

So I have to be honest, and I have to mark it to market, and then say that my assets are now an $800,000 house, my same house, nothing really happened, but the market value has dropped by $200,000 for whatever reason. Maybe the car factory nearby has gone out of business. So in this situation, what happens? What is my new balance sheet? Well, has my liabilities changed because my neighbour's house sold for less? Well, no, as far as the bank is concerned, I still owe $750,000 to the bank. This is a liability. I still owe $750,000. This is assets of course.

So what's my leftover? What would be the leftover if I were to liquidate at the market price, if I were to sell the house at the market price? Well, I would have 50K left over. So essentially, when the market price of my asset dropped, all of that value came out of my equity. – And I'll do actually a whole other video on the benefits and the risks of leverage, because that's very relevant to what's happening in the world today, but I think you get a sense what's happening. Equity kind of takes all of the risk.

So in this situation, this is why the bank wants you to put some down payment because the bank, if you can't pay this loan right here, they're going to take your house, and even in the situation where the value of the house went down, if you can't pay the loan, the bank will still be able to get its 750K, right? If you just leave town or lose your job and you just tell the bank, "I can't pay anymore," they're just going to take this house, sell it, hopefully for 800K because that's what your neighbour sold it for, and they're going to get the money back for their loan. So that’s why the bank wants you to put some down payment.

And then there's the other situation which is maybe a more positive situation, and this is what happened in much of the world and especially in areas like California and Florida and Nevada over the last five years or so, and I'll do a whole video on why it happened, but let's say your neighbour's house a year later didn't sell for $800,000. Let's say the identical neighbour's house sold for $1.5 million, and you say, "Gee, whiz. That's great. Now my house is also worth 1.5 million because I'm marking to market." So now my asset – nothing has really changed, it's still the same house – but I guess since someone else sold it for 1.5 million I guess I could too, so my asset is now a $1.5 million house.

What are my liabilities? Well, your liabilities still haven't changed. I still owe $750,000. That says $750,000 to bank, this is liabilities, so what's left over? What's my equity? Well, assets minus liabilities, so I have $750,000 of equity. That's awesome. Even though the house appreciated by 50%, right, it went from 1 million to 1.5, my equity grew threefold. It appreciated by 200%, and I think you're starting to get the benefits of what happens when you do leverage. Leverage is when you use debt to buy an asset but when you use leverage, the return that you get on your asset gets multiplied when you go the return on your equity. I hope I'm not confusing you.

But in this situation, all of a sudden I have a ton of equity, and I'm running out of time, but in the next video, I'm going to talk about how this happened, because you saw it in a lot of neighbourhoods, a lot of houses appreciated over the last from about 2001 to 2005, and people all of a sudden just sitting on their house ended up with a lot of equity, and they felt that, "Wow, I just went from having $250,000 of net wealth to $750,000 of wealth without doing anything, just by my neighbour's house selling for more." I'll see you in the next video.

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