You bought your home for $500,000 10 years ago in a hot market area. You had a loan on it at the time for $350,000 after putting $150,000 down. In the last decade, you paid down $100,000 of that loan so that your remaining principal is $250,000.
From the bank's "book value" perspective, the loan-to-value ratio is now 50 percent. But the MARKET value of the home today is a million bucks. So that loan-to-value ratio is actually falsely conservative or overly conservative. It's really 25 percent...meaning that the bank's portfolio is safer than it might seem. That's where appraised equity capital comes into play.
By having the home's value appraised for the actual equity in it, the bank gets a different perspective (a much more real market-based one) on its level of risk in its loan portfolio. And this element matters to home owners as well who have Private Mortgage Insurance or PMI...usually required when the loan-to-value ratio is less than 20 or 25 percent. Should the home's equity go up a lot, that LTV gets more friendly and at some point, the home owner can then stop paying the non-tax-deductible PMI fees and save a few more bucks.
The notion of appraised equity capital isn't limited to homes or home loans...it applies to normal corporate bean counting...but you'll hear it most at home mortgage cocktail parties. And then you have to ask yourself, "Why am I here?" But that's a different glossary term.
Related or Semi-related Video
Finance: What is the Difference Between ...42060 Views
finance a la shmoop. what's the difference between market value and book
value? ever tried to sell sunscreen to a white Walker? yeah [zombie walks through snow]
probably won't make much money. want to know why? now learning about the
difference between market value and book value will tell it all. first market
value it's what the market thinks a stock or a bond or a home or a used car
or whatever is worth. the market the crowd the crazy people.
all right here's an example of market value gone wild in the 17th century [crowd then tulip pictured]
Denmark, they valued a single tulip at 10 grand and it didn't even give them a
triple espresso buzz. go figure. but that's how the market of buyers
valued that tulip so that's what that tulips market value was. that's what the
market said it was worth. Book value however is a completely different in a [man walks through art gallery]
somewhat more rational animal .book value is the dollar amount that a company can
point to which reflects an asset they physically own. imagine buying a tractor
factory for 80 million bucks. it depreciates in value 10 million dollars
a year for 4 years then depreciates that 2 million dollars a year after that. so
after five years that factories Book value ie the amount we're guessing its [chart showing depreciation]
value as actually being is 38 million dollars. but lo and behold the factory
itself is made of Valyrian steel .you know that stuff from Game of Thrones
that kills White Walkers. so after eight years and one white Walker invasion of
Chicago later you decide to sell the factory itself because well the stuff [zombies walk in front of skyscrapers]
it's built out of, that rare material, is suddenly worth a lot more than the
factory .now after eight years the book value of the factory might be 32 million
dollars, but some bitter on eBay of tractor companies offers you a hundred
million bucks! and you accept! that hundred million dollars was the market [man sits behind computer screen]
value of the tractor factory even though the book value said it was worth a whole
lot less. securities actually work the same way. they are traded regularly in a
market place and they reflect their market value even though the book value
at which they are held is often a lot less. and what about Chicago well let's [smiling man carries bags of cash]
just say no one's selling much sunscreen these days.
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