Building Equity in a Home

For the homeowner, there are a number of advantages to home ownership, many of which are financial and tax related.

One of the biggest benefits of owning a home, as opposed to renting, is that every month you are actually putting money towards the value of the home, instead of simply giving it to a landlord. This process is referred to as building equity in a home.

What is Equity?

Equity is the difference between the value of the home and the principal of the mortgage. As the principal of the mortgage decreases, the equity increases, however equity can also be influenced by increases or decreases in the value of the home.

Real Life Example of Equity

As an example, lets say that someone purchases a $120,000 with a $12,000 down payment. This means that the principal of the mortgage is $108,000 and they have $12,000 in equity.

Now, lets assume that in five years, the value of the home has increased to $150,000 and they have paid the principal down to $80,000.

Even though the homeowner has only paid $40,000 towards the value of the home, because the homes value has increased, they have $70,000 in equity.

The equity is computed by taking the value of the home($150,000) and subtracting the amount that is still owed on the mortgage($80,000.)

A Word of Caution about Home Equity

It is important to remember that the equity of the home is not real money, in that it is not something you can physically hold. In order to actually earn the equity, the home must be sold and if the value of the home were to decrease, then equity would go down.

It is a common misconception that a homes value is always going to significantly increase, which was fueled by rapid increases in home prices during the 1990’s, when a homes value would sometimes increase by over 20% every year.

Home Equity Loans and Home Equity Credit Lines

While technically, you do not receive your equity until you sell your home, a number of lenders offer home equity loans and home equity credit lines.

A Home Equity Credit Line is much like a credit card, which has a credit limit based off of the homes equity. In most cases, the interest rate will also be very high, like a credit card, but the homeowner is not obligated to use the Home Equity Credit Line.

A Home Equity Loan, on the other hand, is more like a second mortgage. The homeowner will receive a single lump sum, which is based off of the equity of the home. They then have to make monthly payments, which is in addition to their monthly mortgage payments.

Piggybacking Mortgages and Risks of Home Equity Loans

With the rapid increase in home values that took place during the 1990’s, many lenders began offering very large home equity loans, but with subprime mortgage rates. As a result, many homeowners took out these loans and began using them for things like new cars, vacations, or college tuition. Some even began piggybacking their down payment loans, which is when the homeowner takes out a mortgage and a separate loan for the homes down payment at the same time.

Then, the housing bubble burst, home values decreased, which resulted in a lot of people owing a lot more than their home is currently worth. Also, many of those who had received a subprime mortgage faced increasing mortgage payments, which further compounded the issue.

Deciding to take out a Home Equity Credit Line or a Home Equity Loan should not be taken lightly, because if the homes value were to decrease, the equity would also decrease, with the homeowner still being responsible for paying for the home equity loan.