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An equity contribution is an owner's investment in an asset that represents an unencumbered ownership interest. The concept is used in various contexts, including with businesses ownership percentages and loan transactions. It is also important in the purchase of real estate. A person's equity contribution is used to calculate financial positions, such as whether or not an asset is heavily leveraged and to determine an asset's loan-to-value ratio.
The part of an asset that a person owns free and clear is equity. If a person needs to take a loan out against the asset, the equity is the amount that can be put up to secure the loan. Many types of assets that can be obtained by acquiring a loan require the buyer to make an equity contribution so he has an unencumbered ownership interest in the asset. In other contexts, an equity contribution is required of a new asset owner so he has a proportionate ownership interest in the asset with other owners.
The most common example of an equity contribution is the downpayment required of house buyers by the lender that will provide the mortgage. A lender will not typically lend 100 percent of the cost of a house. Lenders require buyers to make an equity contribution of a certain percentage of the purchase price, so the buyers have some ownership stake in the property. The rationale is that the buyers will be less likely to default on the loan if they have an equity stake at risk.
Likewise, a business loan requires an equity contribution from the business owner. Business lenders request financial statements that indicate the entire cost of a project. Then, the lender will often only lend up to a certain percentage of the money needed, requiring the owner to make a contribution to cover the balance. Again, this is supposed to help ensure that the owner has his own money at risk, along with the lender's money.
Another equity contribution context is the capital investments partners make when starting a business. When a group of people want to start a business, each must contribute money, property or services to the business in exchange for an ownership percentage. For example, when a group incorporates a business, each purchases shares of stock that represent a shareholder's ownership interest. That initial purchase is each shareholder's contribution to the enterprise.
Financial analysts use equity to determine the financial position of assets. For example, if a person uses a small contribution to finance an expensive asset, the asset is considered to be highly leveraged, a somewhat unattractive financial position. Likewise, if a home buyer's contribution is very small and the mortgage on the property is very large, the house is said to have a high loan-to-value ratio, which means the loan is highly risky because the owner can more easily walk away from the asset with such a small amount of equity at risk.
@Logicfest -- That mortgage insurance goes away once someone has over 20 percent equity in a home. But reaching that level is not as easy as people might think. That is because of the way mortgages are structured. If you have a 30-year mortgage, you start out paying mostly interest in your monthly payment and those payments cover mostly equity by the end of that term.
30 years is a long time and hitting that 20 percent equity mark is tough when you are paying so much interest at the first of the loan. Plus it is very hard to tell exactly when you hit that magical 20 percent number due to fluctuations in value and such.
That down payment is something to really pay attention to in a real estate transaction. Here is the deal with that. If someone takes out a mortgage without putting down 20 percent of the purchase price as equity, then that person gets the thrill of paying mortgage insurance. While that insurance isn't terribly expensive, it can make the difference between an affordable mortgage payment and one that's just a bit too much.
Want to save some cash? Put 20 percent down on that home loan to avoid paying insurance. That price is too much for a lot of people, but the savings that can be realized might mean it's worth socking some cash away until you can put 20 percent down.