The initial equity in a home is equal to a purchaser’s downpayment. If a buyer pays cash for a home, all equity is initial equity. There is an opportunity cost associated with downpayment money. This cost should be considered when someone considers buying residential real estate.
In the aftermath of a financial fiasco, lenders return to the practices that did not fail them in the past. The only program lenders know empirically to be stable is a 30-year, fixed-rate, conventionally amortizing loan based on 80% of appraised value taking no more than 28% of a borrower’s gross income (36% maximum total debt).
The credit crunch facilitated the decline in housing prices after the housing bubble. Large downpayments came back, and government assisted financing became widely used by first-time homebuyers to overcome the high equity requirements. The credit crunch was not caused by some unexpected or unknown factor; it was caused by the failure of lenders. Credit continued to tighten until lenders stopped making bad loans. The bad loans did not disappear until lenders returned to the stable loan programs with a proven track record. That is how the credit cycle works.
Since most home purchases are financed, this initial equity is usually a small percentage of the purchase price, generally 20%. People can also obtain financing through the FHA and use a 3.5% downpayment. During the housing bubble, people did not need downpayments as 100% financing was very common.
A downpayment is the borrower’s money acquired through careful financial planning and saving, gifts from family members, or from the profits gained at the sale of a previous home. Downpayment money is not “free.” This money generally is accumulated in a savings account, or if a buyer chooses to rent instead, downpayment money could be put in a high-yield savings account or other investments. There is an opportunity cost to taking this money out of another investment and putting it into a house.
It is important to consider opportunity costs with downpayment funds. Most people think money invested in a home makes them money so they should not worry about it. There is some truth to that in an appreciating market. However, when prices are flat or declining, this money would perform much better in an alternative investment strategy. This opportunity cost is part of the cost of owning a home, and it should be considered when a potential buyer is comparing renting to ownership.
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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