Monday, January 19, 2009

Home Equity - What is It?

Many people who purchase real estate have no idea what equity is, what creates it, what destroys it, and what to do with it. 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.

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, it can be broken down into several component parts:

* Initial,
* Financing,
* Inflation, and
* Speculative.

Initial Equity is the amount of money a purchaser puts down to acquire the property. Financing Equity is the gain or loss of total equity based on the decrease or increase in loan balance over time. Inflation Equity is the increase in resale value due to the effect of inflation. This kind of appreciation is the "inflation hedge" that provides the primary financial benefit to home ownership. Finally, there is Speculative Equity. This is the fluctuation in equity caused by speculative activities in a real estate market. This can cause wild swings in equity both up and down.

If life's circumstances or careful analysis and timing cause a sale at the peak of a speculative mania, the windfall can be dramatic. Of course, it can go the other way as well. If a house is purchased at its fundamental valuation where the cost of ownership is equal to the cost of rental using a conventionally amortized mortgage with a downpayment, the amount of owner's equity is the combination of the above factors.

The housing bubble saw many individual properties obtain huge amounts of speculative equity. During this unprecedented rise in real estate prices, there was a surprising decline in aggregate home equity across the country. People did not manage their equity well. Many treated their houses like an ATM machine that provided nearly endless free money. Unfortunately, most of these people lost their homes in foreclosure.

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