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- Understanding Equity and Debt in Personal Finance | Finance 005A
Understanding Equity and Debt in Personal Finance | Finance 005A
Learn how equity and debt play crucial roles in personal finance through an illustrative example of a homeowner buying a house. Explore the concepts of equity from investors and debt from lenders, along with their expectations and considerations for safety and returns.
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Video Transcript
Friends, welcome to video 5a.
This video is supplementary to video 5 in which I had described the concepts of equity
and debt.
In this video, just to illustrate that concept even more, I have taken an example where a
householder buys a house.
Let's look at that example.
But prior to that, let's just quickly revise a couple of concepts.
In that video 5, we did talk about two direct sources of finance, equity and debt.
Equity comes from investors, debt comes from lenders.
You may remember we spoke about it.
We also spoke about the difference in expectations of investors who look for capital appreciation
and who also share profit.
Lenders, on the other hand, look for defined return, which we call as interest, but they
care a lot about safety of their principal and take all
these steps necessary for protecting their interest whether in the form of mortgage,
hypothecation, guarantee and so on.
Now friends let's take an example.
Let us say you have identified a house which costs Rs 50 lakhs or 5 million in international
lingo.
Let us say you invest 10 lakhs of your own and you borrow a sum of Rs 40 lakhs from a
bank.
Can you guess what is equity and debt in this particular transaction?
I am sure you guessed it right. Rs. 10 lakhs or 1 million is equity. Rs. 40 lakhs or 4
million is debt. Now let us assume that the price of the house goes up to 60 lakhs. Let
us also assume that we have not yet repaid any debt. So debt remains the same as 40 lakhs.
However, your equity has suddenly surged to 20 lakhs.
Debt owners always have the residuary claim, whatever remains after paying off debt belongs
to them.
Debt owners don't have any claim on the price appreciation.
On the other hand, let's assume that the price of the house goes down to 40 lakhs.
What happens to debt?
The debt owners will continue to have a claim of 40 lakhs on us.
But the equity has suddenly got wiped out to zero from 10 lakhs.
This is not a theoretical situation.
This actually has happened in practical life.
The entire subprime crisis in the US was about this wiping out of the equity.
In some cases, the equity even became negative.
So friends, I hope this video clarified the concept of equity and debt more clearly for
you.
I would continue to create such supplementary videos to illustrate the main point in the
video, the related video and therefore keep track of these supplementary videos also.
Please press subscribe button in case you have not already done. So, thank you
