Most people understand that having equity in a home is a good thing and that increases in home values contribute to increased equity. Beyond that though, it can get a little confusing. One way to understand equity is in terms of the accounting equation. (Stay with me here, even if you dislike accounting or math.)
Assets = Liabilities + Equity
In words, this equation says that to buy an asset (like a home), you can borrow money to buy it (liability), you can pay for it out right (equity), or a combination of the two. A combination is most popular for home buying.
Let’s say you bought a house for $200,000 and you put down 20% ($40,000). Here’s how the equation would look:
Assets = Liabilities + Equity
$200,000 = $160,000 + $40,000
As you can see, initially when you buy a home the amount of your down payment is equal to your equity. Let’s look at some scenarios that affect homeowner’s equity.
What if home values immediately increased 10%? The home’s value would increase to $220,000:
Assets = Liabilities + Equity
$220,000 = $160,000 + $60,000
In this example, a 10% increase in the home’s value leads to a homeowner’s equity increase of 50% ($40,000 to $60,000). Over time, the home’s value should increase and at the same time the loan is getting paid down. After some time, for example, the home might be worth $260,000, and you might owe $130,000:
Assets = Liabilities + Equity
$260,000 = $130,000 + $130,000
In this example, the homeowner would own 50% of the home.
What happens, though, if home values decrease 10% immediately after purchase?
Assets = Liabilities + Equity
$180,000 = $160,000 + $20,000
A 10% drop in the home’s value leads to a 50% decrease in homeowner’s equity ($40,000 to $20,000)! This is why lenders require down payments of 20% for the buyer to avoid paying mortgage insurance. If this homeowner were to stop paying their mortgage, the bank would foreclose on the home and become the owner of a $180,000 house, even though they only loaned $160,000.
Let’s look at the same scenario with a 3.5% down payment, which is acceptable for FHA loans:
At purchase:
Assets = Liabilities + Equity
$200,000 = $193,000 + $7,000
With a 10% housing market crash:
Assets = Liabilities + Equity
$180,000 = $193,000 + -$13,000
In this scenario, if the lender foreclosed, they would own a home worth $180,000 that they loaned $193,000 on. The buyer, however, was paying mortgage insurance premiums, so the insurer pays off the mortgage and the lender is protected. The insurer collects enough mortgage insurance premiums from homeowners that do not default to cover the mortgages of those that do.
Historically, housing prices have risen consistently. There have been dips in the housing market from time to time, with the largest being in 2008. Some homeowners had so much negative equity in their homes that they stopped making their payments and simply walked away. Others continued to make their payments until the housing market rebounded. Some homeowners bought after the crash, like me, and benefitted from the rising housing market.
Buying a home means taking on risk. The market might go up, or the market might go down. These examples illustrate the risk you take when you buy a home and explain the ways a homeowner’s equity can increase or decrease.
What do you think? Is home equity easier or more difficult to understand than you thought?
For ways homeowners can borrow their own equity, check out this blog, Home Equity Line of Credit vs Home Equity Loan.