What is home equity?

By: Dian Hymer

October 06, 2003

Homeowners are wealthier than renters, by an enormous margin, according to the 2003 State of the Nation's Housing report from Harvard University's Joint Center for Housing Studies. At the end of 2001, the median household net worth of homeowners was $171,800 compared to only $4,810 for renters. Home equity accounted for the huge disparity in household net worth.

Home equity is the difference between the value of a home and the liens (usually mortgages) secured against it. If you buy a $100,000 home using a 10 percent cash down payment and a 90 percent mortgage, you will have $10,000 equity in the property.

HOUSE HUNTING TIP: One of the benefits of buying real estate is that you can buy an expensive asset with a relatively small amount of your own cash. This is called leverage. As your home increases in value over time called appreciation you earn appreciation on the entire property, not just on your down payment amount.

For example, if the property above were to increase 7 percent in just one year, the property value would rise 7 percent to $107,000. However, your equity would increase 70 percent from $10,000 to $17,000. This is the beauty of leverage.

However, leverage can backfire if property values drop significantly and you have to sell your home. If the value of the home above fell 7 percent, you'd be lucky to break even when you sold. The costs of sale, such as the brokerage commission, lender fees and transfer taxes, would diminish your equity, perhaps completely. In fact, you might have to contribute additional cash to close the sale.

Despite periods of deflation, single-family residences in this country have tended to appreciate over time. Over years of home ownership, home price appreciation can substantially increase your net worth. Other ways to build equity include paying down your mortgage and increasing the value of your home through cost-effective home improvements.

Some mortgages help build equity faster than others. An amortized loan is completely paid back during the loan term. A portion of each monthly payment pays the interest owed and a portion goes to paying back the amount borrowed (called principal). So if you borrow $90,000 and it's paid back with amortized payments over 30 years, you owe the lender nothing at the end of that time. When you pay the loan off, you'll have an additional $90,000 equity in the property.

The shorter the term of a fully amortized mortgage, the quicker the equity build-up. You build equity faster with a 15-year amortized loan than you do with a mortgage that's amortized over 30 years.

Interest-only loans aren't amortized, so you will not build equity by making monthly payments on an interest-only mortgage. Adjustable rate mortgages (ARMs) that have payment caps can actually deplete your equity. This is called negative amortization.

Negative amortization occurs when interest rates rise and you chose to make the minimum monthly payment due. If the capped payment doesn't fully pay the amount of the interest owed, the unpaid interest is added to your principal balance. So the amount you owe on your mortgage increases rather than decreases.

Another way to deplete equity is to refinance into a larger mortgage, take the difference in the two loan amounts in cash, and spend it. Americans have been doing cash-out refinances at a record pace recently. Increased leverage has depleted homeowner's equity by about 15 percent over the past 20 years, according to Federal Reserve figures.

THE CLOSING: Letting a property fall into disrepair is another way to diminish your equity. Keeping your home well maintained helps to protect your equity.

Dian Hymer is author of "House Hunting, The Take-Along Workbook for Home Buyers," and "Starting Out, The Complete Home Buyer's Guide," Chronicle Books.

Distributed by Inman News