Welcome back. Where we left off in the last
video, I had just purchased a $1 million house. To do it, I went to the bank and
I said, bank, can you give me $750,000? They said, sure, Sal, you have
an excellent credit rating, 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. After that transaction, this is
what my personal -- well, this might not involve
everything, but it 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 $1 million 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 $1 million house. And what are my liabilities? Well I owe $750,000
to the bank. And so we learned in the last
video -- 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,
assets minus liabilities is equal to equity, right? Subtract the liability
from both sides. And you know that 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 I would have
$250,000 left. So that's what equity is, just
what you have left after you resolve everything. Or another way -- and this
makes sense to you. If you talk about all 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 market value
of the house changes. So let's say, what happens when
-- 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 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 is 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. And so what I say is, OK, well,
you know I'm taking this loan out to buy a house,
a $1 million 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 $1
million 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 lost my job, I can't afford the mortgage. They get a $1 million
house overnight. They would have made
$250,000, right? They would have essentially
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 onto 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
you know, whatever. I just drink away all of
my money, whatever the case may be. And so the bank,
they foreclose. Foreclose means that Sal isn't
paying on 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 maybe they're not
going to get $1 million 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, or -- we won't
go into all of that. But it will auction off the
house, and maybe it can only auction off the house
for $800,000. Right? So the $1 million asset
would really become an $800,000 asset. And so the bank keeps this
equity cushion, right? That if they loan $750,000 for
a $1 million house, and then the $1 million house only sells
for $800,000, the bank still gets all of their
money back. That's why, in the good old
days, the banks wanted 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 assets. The banks says well then,
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 let's say a neighbor's house sells for-- a 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 revalue it. I cannot in all honesty say that
this is now worth, that this is a $1 million asset. So I would revalue the asset. And this is actually called
marking to market. You probably heard
of this concept. Marking to market 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 is worth is to see what identical assets
like that are going for on the market. And very few houses are
completely identical. Well there are, in
a few suburbs. Very few assets 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 liability changed,
because my neighbor'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 leftover? What would be 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 $50,000
left over. Essentially when the market
price of my asset dropped, all of that value came
out of my equity. 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
of 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
$750,000, 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 $800,000, because that's what your
neighbor 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 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 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 to bank. This is liabilities. So what's left over? What's my equity? Well, assets minus liability. 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
million, my equity grew three-fold. It appreciated by 200%. 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
get 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 neighborhoods. 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 having $250,000 of net wealth to $750,000
of wealth, without doing anything. Just by my neighbor's house
selling for more. I'll see you in the next video.