Learn about More on balance sheets and equity Video

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Learn about More on balance sheets and equity

Welcome back and 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 $750,000. They said, sure Sal you have an excellent credit reading and you look like an all around great guy, so we’ll give you $750,000. And 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. In my balance sheet I have 1 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 so we learn in the last video and you should have used this as a formula. It should start to make a little a bit intuitive sense that assets are equal to liability plus equity. Or the other way to do it is asset minus liability is equal to equity. Just subtract the liability from both sides and you know that if I have a million dollar assets, I owe $750,000. If I were to resolve everything, what I have left over at the end is $250,000. And I can make that happen. I could sell the house for a million dollars hopefully and then pay the bank back and I’ll have $250,000 left. So that’s what equity is. It’s what you have left after you resolve and everything. This makes sense. So if you took about all of the things you own minus all of the things you owed to other people, equity is what’s left over. And that could be owner’s equity. So now lets play with some scenarios of what happens maybe when the value, the market value of the house changes. So let’s say what happens when, oh and one important thing you note is this bank, they’re not just going to give me $750,000 just to do anything with it. They’re not going to say, hey Sal here’s $750,000, I know you’ll pay it back to me but you can go gamble it 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 back or it has to be collateralized by some asset. And so what I say is okay, well you know, I’m taking this one out to buy the house, a million dollar house, if for whatever reason I lose my job or I disappear somehow or whatever happens, if I cant 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 had to say, you know what bank I can’t pay this loan, I don’t have the income or I lost my job, I can’t afford to mortgage. They get the million dollar house. Overnight they would have made $250,000 right. They would essentially get on my equity for free. So in that situation, the bank works up pretty good. 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, 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 the house. Because there’s a situation where lets say that I do this, I borrowed the money, and I bought the house, and I lose my job or whatever, I just drink away all of my money. Whatever the case maybe. And so the bank and they foreclose. Foreclose means that Sal isn’t paying on his 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. When they take that house, there’s a situation where 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 laws that it can’t get more than the mortgage or anything more than the mortgage it gets. It actually has to pay taxes. They’ll auction off the house and maybe can only auction off the house for $800,000. So the million dollar asset will become an $800,000 asset. And so the bank keeps this equity cushioned. That if they loan $750,000 for a million dollar house, and then the million dollar house sells for $800,000, 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 house, the value of the house drops by 20 or 25%, it will 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 assets. The bank says, well I want that house back. So in that situation, 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 lets say a neighbor’s house sells for, the neighbor’s house that is identical, an identical neighbor’s house sells for $800,000, right. 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 re-value it. I cannot in honesty say that this is a 1 million dollar asset. So would re-value the asset. And this is actually called marking the market. You probably heard this concept. Marking means I have an asset and every now and then, maybe every few months, every quarter. A quarter is 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 worth is to see what identical assets like that are going for the market. And very few houses are completely identical but there are kind of a few suburbs. But a very few asset is completely identical but lets 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 market 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 near by has gone out of business. So in this situation, what happens? What is my new balanced sheet? Well, has my liabilities changed because my neighbor’s house sold for less? Well no, I still owe, as far as the bank is concerned. I still owe $750,000 to the bank. I still owe $750,000, this is a liability. I still owe $750,000, this is assets of course. So what’s my left over, what would be the left over 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. Right. And this is, I’ll do actually a whole other video one the benefits and risk of leverage because that’s very relevant to what’s happening in the world today. But I think you got a sense of what is 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, their going to take your house. And even in the situation where the value of the house went down, if you can’t pay the 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 the house, sell it, hopefully for 800k. Because that’s what your neighbor sold it for, and they’re going to get the money back for their loans. 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 video on why it happened. But let’s say your neighbor’s house, a year later didn’t sell for $800,000. Let’s say the identical neighbor’s house sold for $1.5 million. And you say gee wheeze, that’s great. Now my house is also worth for $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 to. So my asset is now $1.5 million house. But my liabilities still haven’t change. I still owe $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 percent, right, it went from a million to 1.5. My equity grew three folds. It appreciated by 200 percent. And this is I was just trying to get the benefits of what happens when you do leverage. Leverage is when you use debt by an asset. But when you use leverage, the return you get on your asset gets multiplied when you go the return in your equity. Hopefully I’m not confusing you. But in this situation I also have a ton of equity and I’m running out of time. For the next video I’m going to talk about this happen. Because you saw in a lot of neighborhood a lot of houses appreciated 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 just having 250,000 net wealth to 750,000 of wealth without doing anything. Just buy my neighbor’s house selling for more. I’ll see you in the next video.

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Welcome back and 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 $750,000. They said, sure Sal you have an excellent credit reading and you look like an all around great guy, so we’ll give you $750,000. And 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. In my balance sheet I have 1 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 so we learn in the last video and you should have used this as a formula. It should start to make a little a bit intuitive sense that assets are equal to liability plus equity. Or the other way to do it is asset minus liability is equal to equity. Just subtract the liability from both sides and you know that if I have a million dollar assets, I owe $750,000. If I were to resolve everything, what I have left over at the end is $250,000. And I can make that happen. I could sell the house for a million dollars hopefully and then pay the bank back and I’ll have $250,000 left. So that’s what equity is. It’s what you have left after you resolve and everything. This makes sense. So if you took about all of the things you own minus all of the things you owed to other people, equity is what’s left over. And that could be owner’s equity.

So now lets play with some scenarios of what happens maybe when the value, the market value of the house changes. So let’s say what happens when, oh and one important thing you note is this bank, they’re not just going to give me $750,000 just to do anything with it. They’re not going to say, hey Sal here’s $750,000, I know you’ll pay it back to me but you can go gamble it 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 back or it has to be collateralized by some asset. And so what I say is okay, well you know, I’m taking this one out to buy the house, a million dollar house, if for whatever reason I lose my job or I disappear somehow or whatever happens, if I cant 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 had to say, you know what bank I can’t pay this loan, I don’t have the income or I lost my job, I can’t afford to mortgage. They get the million dollar house. Overnight they would have made $250,000 right. They would essentially get on my equity for free.

So in that situation, the bank works up pretty good. 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, 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 the house. Because there’s a situation where lets say that I do this, I borrowed the money, and I bought the house, and I lose my job or whatever, I just drink away all of my money. Whatever the case maybe. And so the bank and they foreclose. Foreclose means that Sal isn’t paying on his 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. When they take that house, there’s a situation where 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 laws that it can’t get more than the mortgage or anything more than the mortgage it gets. It actually has to pay taxes. They’ll auction off the house and maybe can only auction off the house for $800,000. So the million dollar asset will become an $800,000 asset. And so the bank keeps this equity cushioned. That if they loan $750,000 for a million dollar house, and then the million dollar house sells for $800,000, 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 house, the value of the house drops by 20 or 25%, it will 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 assets. The bank says, well I want that house back. So in that situation, 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 lets say a neighbor’s house sells for, the neighbor’s house that is identical, an identical neighbor’s house sells for $800,000, right. 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 re-value it. I cannot in honesty say that this is a 1 million dollar asset. So would re-value the asset. And this is actually called marking the market. You probably heard this concept.

Marking means I have an asset and every now and then, maybe every few months, every quarter. A quarter is 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 worth is to see what identical assets like that are going for the market. And very few houses are completely identical but there are kind of a few suburbs. But a very few asset is completely identical but lets 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 market 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 near by has gone out of business.

So in this situation, what happens? What is my new balanced sheet? Well, has my liabilities changed because my neighbor’s house sold for less? Well no, I still owe, as far as the bank is concerned. I still owe $750,000 to the bank. I still owe $750,000, this is a liability. I still owe $750,000, this is assets of course.

So what’s my left over, what would be the left over 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. Right. And this is, I’ll do actually a whole other video one the benefits and risk of leverage because that’s very relevant to what’s happening in the world today. But I think you got a sense of what is 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, their going to take your house. And even in the situation where the value of the house went down, if you can’t pay the 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 the house, sell it, hopefully for 800k. Because that’s what your neighbor sold it for, and they’re going to get the money back for their loans. 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 video on why it happened. But let’s say your neighbor’s house, a year later didn’t sell for $800,000. Let’s say the identical neighbor’s house sold for $1.5 million. And you say gee wheeze, that’s great. Now my house is also worth for $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 to. So my asset is now $1.5 million house. But my liabilities still haven’t change. I still owe $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 percent, right, it went from a million to 1.5. My equity grew three folds. It appreciated by 200 percent. And this is I was just trying to get the benefits of what happens when you do leverage. Leverage is when you use debt by an asset.

But when you use leverage, the return you get on your asset gets multiplied when you go the return in your equity. Hopefully I’m not confusing you. But in this situation I also have a ton of equity and I’m running out of time. For the next video I’m going to talk about this happen. Because you saw in a lot of neighborhood a lot of houses appreciated 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 just having 250,000 net wealth to 750,000 of wealth without doing anything. Just buy my neighbor’s house selling for more.

I’ll see you in the next video.

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