People who purchase real estate use the phrase “building equity” to describe the overall increase in equity over time. However, it is important to look at the factors which either create or destroy equity to see how market conditions and financing terms impact this all-important feature of real estate. Over time, the method of financing used has the greatest impact on the total amount of home equity.
In simple accounting terms, equity is the difference between how much something is worth and how much money is owed on it (Equity = Assets, Liabilities). For purposes of illustration, equity can be broken down into several component parts:
* Initial Equity,
* Financing Equity,
* Inflation Equity, and
* Speculative Equity.
Financing equity is determined by the terms of the loan. With a conventionally amortizing mortgage, a portion of the payment each month goes toward paying down the loan balance. As this loan balance decreases, the owner’s equity increases. This is a substantial long-term benefit of home ownership.
With an interest-only mortgage, the loan balance does not decrease because only the interest is paid with each payment. With this kind of loan, there is no financing equity. One of the major drawbacks of using an interest-only loan does not become apparent until the house is sold and the seller wants to take the equity to the next home in a move-up. Since no financing equity has accumulated, the seller obtains less equity in the transaction. This means the move-up buyer will be able to afford less.
Over the short-term, financing equity is not significant because the loan balance is not paid down by a large amount, but if the house has been held for 10 years or more, or if the loan was amortized over a shorter term, the financing equity can be a large amount. This can make a real difference when the total equity amount is to be put toward a larger, more expensive home. Also, financing equity is a great reservoir for retirement savings. In fact, it is the primary mechanism for retirement savings of most Americans outside of social security.
The worst possible loan is the negative amortization loan because of its impact on equity. If a negative amortization loan is utilized, it will consume all equity in its path. It is a form of cash-out financing that reduces equity. This loan relies on inflation and speculative equity to have any equity at all. The negative amortization loan will only begin to build financing equity after the loan recasts and becomes a fully-amortized loan and the payments skyrocket, assuming the borrower does not default. Most people cannot afford the fully-amortized payment, or they probably would not have used this form of financing initially. Even after the recast and the dramatic increase in payments, the loan does not get back to the original balance for many years.
Many people experimented with exotic loan terms during the housing bubble. Most used financing terms which either failed to add to equity or actually consumed it. They did this to “tread water” and attempt to capture speculative equity which was accumulating rapidly during the bubble rally. In the end, most people who used these forms of financing lost a great deal of money, and many ended their ownership tenure in foreclosure.
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/
Read the author’s daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/
[tags]housing, real estate, buying real estate, housing bubble, real estate bubble, house for sale[/tags]
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