15

My wife and I are considering buying a home soon - some of the major reasons are personal, such as being able to perform repairs and updates to the property, and having the security and peace of mind of owning our own property.

But one thing that I'm a little nebulous on as a benefit is the thing that people always quote at me as a benefit to buying a home - Equity.

My basic understanding is that Equity is "How much 'loan' you've paid off on a home", and that by buying a home, we can store up equity for the future if we want to move to another home, or to borrow against it in case of emergencies (a "home equity loan").

Do I understand the benefits of home equity correctly? Or is there something I'm missing from this?

  • 9
    Equity is not just how much you've paid off, it is also any appreciation in value. Of course equity is hard to quantify until you sell your home, so for borrowing purposes, they would go by the appraised value. – Ron Beyer Jan 7 at 15:04
  • The only thing equity does is to let you to take out a loan using your home as collateral. This does have advantages though, usually interest rates are lower so you could take out a loan for a car using home equity. It is also a potential source of money for debt, such as health bills. – Tracy Cramer Jan 7 at 23:38
  • 4
    When you and your wife are 95 years old and decide to live it up, you can sell your house for a million future dollars and go on a tear. That's what equity is. – J... Jan 8 at 1:14
22

Broadly-speaking, equity just refers to (the value of) what you own, after deducting what you owe.

The accounting equation is: Assets - Liabilities = Equity. - investopedia

So if you have $100k in cash (and no loans) and you borrow $200k to buy a $300k property, your equity before and after the purchase is the same. You started with $100k equity and you ended with $300k - $200k = $100k equity.

Suppose you get a bill for $10k.

  • If you kept your original $100k in the bank and didn't buy the $300k property, you can just draw $10k from your bank account to pay for it, leaving your equity at $90k.
  • If you borrowed to buy the property, you can increase your mortgage by $10k (assuming you have the appropriate redraw privileges) to pay for it, leaving your equity at $300k - $210k = $90k.

Unsurprisingly, both possibilities give you the same equity.

Loan repayments come from income. If you get $10k worth of income and pay that into your mortgage, your assets are $300k (property) + $10k (income) = $310k. So your equity is $310k - $200k = $110k. If you didn't take out the loan, adding the $10k income to your $100k cash in the bank nets you $110k equity.

Now, if your property appreciates in value, say from $300 to $350k, your asset has now increased in value. Ignoring income, loan repayments and interest for simplicity, your equity has now increased: $350k - $200k = $150k. The increase in equity comes from your investment. If your house price depreciates, your equity drops by a corresponding amount. In the other scenario, had you invested your cash into shares and the shares appreciated by $50k, your equity would also have increased to $150k.

Earning bank interest works the same way to increase your equity, and paying mortgage interest does what you'd expect to decrease your equity.

You ask:

What does “Home Equity” do for me?

It does exactly the same for you as "cash" equity does, except that cash at bank tends to be easier to withdraw. You can draw on your home equity only if your mortgage arrangements let you increase your loan.

But once you've taken on a mortgage, the 'value' of your house becomes something of a nebulous figure. You can't easily give the bank a third of the bricks to exchange for $100k. And what you paid for the house may not be what someone else might want to pay. By playing with the asset figure (the house price as valued by the bank), the bank effectively plays with your equity figure. If they say they only recognise $250k of your house price, then your equity becomes $250k - $200k = $50k, instead of the $100k cash you had before buying the house.

Conversely, if the bank says your house is worth $400k, then your equity becomes $400k - $200k = $200k. Note that if you did borrow that additional $200k ('unlocking' the equity in your home), you now have a loan of $400k. Should the bank require it back, you'd need to sell your house. If you can't get a price of at least $400k clear of fees, then you'd have negative equity. Say you sold the house at $350k. Your assets are now $350k, but your liability is still at $400k, so your equity is $350k - $400k = -$50k. In this situation, you owe the bank money and have nothing with which to repay. This is a bad position to be in.

Whether it makes sense to buy a house - that depends on your situation and your own disposition. But buying a house doesn't increase your equity. It just changes it from cash to a more nebulous form of (house price minus loan amount).

Disclaimer: I am not a financial advisor and the above is not financial advice. If you intend to invest in property, please seek your own financial advice.

  • buying a house doesn't increase your equity - Though it's important to keep in mind that your equity over time will almost certainly be higher when owning a house as opposed to leasing/renting a property. – 0x5453 Jan 7 at 23:02
  • It's also worth comparing to rent where you pay cash and don't even get equity in return, you get nothing (apart from permission to live there). – user253751 Jan 7 at 23:23
  • 2
    Maybe this is being pedantic, but what we generally refer to as the accounting equation is "Assets = Liabilities + Equity". As you may know this is how they are presented on the balance sheet and represent "What you possess = What you owe + What you own after paying others". I understand you can substract liabilities from both sides and get the equation you quoted but this wouldn't be called the accounting equation. – ApplePie Jan 8 at 2:01
  • @ApplePie Fair enough, that sounds reasonable. The formulation I quoted came from investopedia, including the bit that says "The accounting equation is". I guess they presented it that way because Equity was the topic at hand. – Lawrence Jan 8 at 15:45
  • 2
    @0x5453 You aren't guaranteed an increase in equity from owning a home. If you move too soon or your home decreases in value you can lose equity from interest, fees, and closing costs. – Chris Jan 8 at 16:16
12

Do I understand the benefits of home equity correctly?

Sort of - equity is essentially the value of the home minus what you owe on it. So if you make a mortgage payment that pays off the principal by $100, then you increase your equity by $100. When you sell your home, the amount that you sell the home for less the amount that you owe is your remaining equity. So if the value of the house has gone up since you bought it, then you'll have some additional equity over what you've paid off.

The problem is the rest of the payment is in interest that has no benefit to you (other than possibly a tax deduction). So in a sense, owning a home lets you pay yourself money by paying down the loan and increasing equity, but it costs you in interest.

  • Which, compared to Renting where 100% of what I pay goes to living, is still better than what I'm getting right now - but I hadn't considered that the interest doesn't count towards equity! I also assume, if through manual labor I improve the value of the house, my equity would also go up? – Zibbobz Jan 7 at 17:36
  • 2
    Probably not much unless you do a major remodel or addition. Minor stuff like changing out an appliance or fixing something that's broke might make it easier to sell but you generally don't get all of your cost back. – D Stanley Jan 7 at 17:41
  • 9
    @Zibbobz It is useful to me to consider what you are getting instead of equity when you are renting. You get the ability to leave and move around with a lot less complication and you are essentially paying a flat fee for all maintenance. Buying a home is definitely cheaper, but you're often stuck with it for at least five years. If you sell before then, you run the risk of having paid more in closing costs/repairs then you earned in equity. – Jason Bray Jan 7 at 18:08
  • It also let's you leverage, so you can get another loan for a car or a boat if you need / want. – vikingsteve Jan 8 at 13:00
2

This comes up a lot when people are considering renting or purchasing, and "equity" in the home is given as a "pro" of home buying. The other answers are correct in explaining what it technically means, but in simple month-to-month terms, the benefit is pretty simple.

Say you are paying $1000 in rent. That money is gone forever. It's 100% an expense that covers the cost of the property, taxes, maintenance, etc. Now when you have a $1000 house payment, you're also paying "fees" that you will never see again (taxes, insurance, and of course interest), but a portion of that monthly bill goes towards "equity" in the home. It pays off your loan balance, and when you sell, you get that money back (simplifying and assuming you sell for the same price you purchased). So, in this case of comparing to rent, equity means that you will eventually get back some of the money you are paying every month rather than it being a 100% expense.

This also helps when comparing the payments between a 15yr and a 30yr mortgage. Knowing that every payment made on a 15yr loan helps me build a much higher percentage of equity makes me feel a lot better about it even though in simple terms, the 15yr payment is "more expensive".

1

Equity is the value available to you out of the asset you own. If you owe on a house then you pay interest for borrowing money against the assets equity.

The equity is part of your net worth. The asset (house) adds to your net worth. The mortgage or home equity loan subtracts from your net worth. The more you borrow against the equity in your asset, the less equity remains in that asset. The cost for using the equity in your asset is called interest and is typically based on a percent of what you borrowed (remaining balance of your loan). Once the loan is paid off, you no longer get charged interest.

The equity can grow or shrink depending on the asset type. Appreciation of the asset (growth of it's value over time) will increase your equity. Typically, traditional built homes and the land on which they set will appreciate. If the asset decreases in value (mobile home, cars, etc.) you'll lose equity over time. You can also lose value by not maintaining your asset.

So to answer your question, Home Equity can provide the following: - You can borrow against the equity (paying interest to do so) for money to do other things with. - You can use it as a means of savings. If you owe nothing and your asset appreciates, then you continue to grow your net worth. You will need to sell your asset to access that savings (which means it's harder to spend because the money is not readily available).

Banks want you to borrow against your home because it makes them money on the interest. Look at the amortization table to understand that the interest charged is more substantial at the beginning and principal (remaining balance) reduction is less. As the loan amount reduces, more of your payment will be applied to principal reduction and less on interest. Therefore banks make more at the start of the loan. There are a lot of things to consider before using the equity in your home.

0

Two things home equity does for you that have been kind-of touched so far but IMHO deserve being spelled out:

  • One thing you mention already in your question:

    being able to perform repairs and updates to the property

    This personal ability plus being as home owner you have some more freedom to choose between paying someone else for doing such work (if you have money but are short on time) or do it yourself (if you have the time). This is a choice you don't have when renting: for many repairs there the landlord decides who does them and you have to pay.

  • It has already been mentioned that the house is a rather illiquid form of equity. Another possibly very beneficial side effect of becoming a home owner is that the mortgage may act as a long-term (self en)forced savings plan which may get you into more frugal habits in general.
    Where I live (Germany) the majority of people rents, and there's no stigma to renting. Also, from a purely wealth-building point of view, you may be better of saving and investing the money that goes into building up the house equity (assuming interest and maintenance costs are roughly equal to the rent and typcially also assuming that you won't do significant repair or improvements yourself). This is a reason you do hear people give for not buying a house. Anyways, home owners on average end up being far more wealthy than non-home owners with similar income, and their savings rates are 2 - 3 times the actually observed savings for the non-home owners. Two reasons for this are being discussed: on the one hand, personal/character traits: people who buy a house may be on average more of a savings-type of person than people who don't (people who don't even manage to save the down payment usually do not get into the home owner group). But there is also that enforced savings aspect: It is far more difficult to withdraw money from the house equity than from savings or an investment account, so this may act as a barrier against consume. In fact, the non-home owners consume more. Also, home owners are observed to stay with a more frugal life style after the house is payed off - after 10+ years of enforced savings they are thought to have formed in general more frugal habits which they keep - thus building more wealth.
    In case you read German, here's a relevant newspaper article and press release.

    There are probably further factors that interrelate: e.g. in rural areas, owning is far more common than renting. Property is also far less expensive (not only absolutely but also relative to the regional average wage). And a more rural lifestyle may overall be cheaper and have less keeping-up-with-the-Jonses pressure: having friends over for a BBQ in your garden tends to be cheaper than meeting in a pub. Walking in the nearby hills or just out of your garden door is cheaper than a weekend trip to ski in the Alps...

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.