The Dynamics of Home Equity

For many people, their home is their largest asset and their best performing investment.  The equity in a home is the difference in what it is worth and what is owed.  Two dynamics, appreciation and unpaid balance, work in concert to make homeowner's equity grow.

It can be said that you appreciate the fact that your home is your best financial investment.  It is also ironic that the appreciation, the increase in value, is what causes it to be your best financial investment.

In a one-year period, the increase in value divided by the beginning value will determine the rate of appreciation for the year.  News stories and articles, frequently, report statistics on appreciation for the month, the year or longer. In many cases, a national appreciation is mentioned but the local appreciation is more reflective of an individual property.

The National Association of REALTORS® reports "The median existing-home price² for all housing types in June was $363,300, up 23.4% from June 2020 ($294,400), as every region recorded price jumps. This marks 112 straight months of year-over-year gains."

The low inventory being experienced nationwide has caused some significant appreciation that has increased homeowners' equity.  According to Black Knight, a mortgage technology and research firm, at the end of 2020, roughly 46 million homeowners held a total of $7.3 trillion in equity.

If a homeowner has a mortgage on their home, while the home is appreciating, the unpaid balance is declining.  An increasing portion of each payment is applied, when the payment is made, to the principal balance to retire the debt based on the term of the loan.

Each month the equity in the home becomes larger because the home is worth more due to appreciation and the unpaid balance is less due to amortization.

Once a homeowner has sufficient equity in their home, they can borrow against it and take cash out of their home.  Most lenders require that the homeowner maintain at least 20% equity position.  This means that owners can borrow up to 80% of the appraised value less the amount that is currently owed on the property.

The options include a cash-out refinance mortgage or a home equity line of credit, HELOC.  While some institutions have stopped offering HELOCs, they are still available.

 The HELOC is a line of credit that is established for usually ten years.  The owner is approved, and the money is available to draw out as needed.  The interest is calculated daily.  Like a credit card, when the balance is paid down, the unused portion of the available credit is available again.

Your real estate agent may be able to offer some lender suggestions.

Doing Nothing is Costing Something

It has been said that more money has been lost due to indecisions than ever was due to making the wrong decisions.  Many times, the larger the decision, the more likely procrastination comes into play and doing nothing will cost something. 

Buying a home is certainly one of the biggest decisions people make.  Careful consideration and planning are necessary steps leading to a prudent decision.  Considering today's market that includes a global pandemic, financial volatility, and rapidly rising home prices, it is understandable that many people thinking about a home purchase are in a wait and see posture.

However, there is a cost connected to waiting and it may be a lot more than you think.  The recent Home Price Expectation Survey 2021 Quarter two estimated appreciation rates will average just under 5% annual for the next five years.  It expects prices to increase by 8% in the next one year. 

Being a renter or even putting off moving to a larger home, could keep you from enjoying the benefit of that appreciation.  If your down payment is in the bank, your expected earning will be less than 2%.  In a home, the owner has the benefit of leverage when a mortgage is used to finance the home.

Buyers are borrowing a large portion of the purchase price at around 3% interest but the entire value of the home is appreciating at a higher rate and the profit builds equity for the homeowner.

Another major component for the owner is that the amortizing mortgage is being reduced with each payment that is made.  As the home goes up in value due to appreciation, the unpaid balance goes down with principal reduction creating equity from two directions.

If you waited one year to buy a $350,000 home today, the price could easily be $378,000.  A 5% down payment on this home at today's price is $17,500.  If you could earn 2% on a certificate of deposit, it would be worth $17,850 in one year.  If it is used as a down payment on a $350,000 home that appreciates at 8%, the equity in one year would be $52,442. Use the Your Best Investment calculator to make your own projection.

Mortgage experts anticipate rates to rise by 0.75% in the next year which means that you'll pay more interest on a larger mortgage by waiting.  The monthly payment could easily be $200 more by waiting a year.  Based on how long you intend to be in the home, it could make the overall housing cost much more.

To run some examples of projections based on your own expectations and at the price you are considering, go to Cost of Waiting to Buy and Rent vs. Own.

If you have some specific concerns that are keeping you from deciding today, let's get together on the phone, an online meeting or somewhere face-to-face so that you can get the facts about what it takes to buy a home now.

Property Inheritance

Stepped-up basis is an incredible benefit to people who inherit property.  Not only do they receive the property itself, the basis or cost value of the property becomes the fair market value at the time of the decedent's death.  This avoids recognizing the gain between the decedent's cost and what it is worth when it is inherited.

If a person had purchased a home for $100,000 and 20-years later when they died, it was worth $500,000, there would be a potential gain in the property of $400,000.  However, because of a tax provision called step-up tax basis, the person inheriting the property will have a basis of the fair market value at the time of death.

The recipient could sell the property for $500,000 and have no taxable gain on the sale.

A formal appraisal is the most reliable and defensible estimate of fair market value at the time of the decedent's death.  There will be a fee of several hundred dollars for the appraisal.  Another alternative is to get a broker's opinion of value in writing.  It may be reasonable to get three opinions to see if they are similar.  They should rely on comparable sales to justify their position.  Either method is acceptable to IRS.

There is discussion from the current President about the possibility of eliminating the step-up in basis that allows families to leave assets to their heirs without having to pay capital gains tax.  Some people consider it to be a tax loophole for the ultra-rich but it can impact ordinary people who inherit property and do not want to have to sell it. 

An example would be a family farm that when inherited by the heirs may not be able to afford to pay the capital gains tax due at time of transfer and they could be forced to sell the property or borrow the money to pay the tax, assuming that was possible.

Federal estate tax is paid from the deceased's remaining estate, not by the heir.  If the decedent's estate is approaching the limit before estate taxes are due, currently $11.7 million, professional tax advice should be considered because there could be additional provisions in play.  More information on this can be found on IRS.gov.

Less to Own than to Rent

The question is "financially speaking, are you better off owning than renting in the long term?"

Renting a home has advantages.  It is usually a short-term commitment from year to year and the landlord is responsible for the repairs.

Owning a home with today's low mortgage rates, the total house payment could easily be less than what the rent would be on a comparable home.  Once you assume ownership, you will have the responsibility of the repairs and possibly, a homeowner's association fee.

Many times, an initial benefit of owing a home includes the ability to deduct property taxes and qualified interest on the mortgage.  With the increase of the standard deduction and a limit of $10,000 on state and local taxes, it is estimated that 90% of homeowners do not itemize their deductions to consider property tax and mortgage interest.  This comparison will not consider them.

There are two very significant benefits that contribute to a home being an excellent investment and they are principal reduction due to normal amortization of the mortgage and appreciation of the property.  While the property goes up in value and the unpaid balance decreases, the owner's equity grows, increasing their net worth.

Renters do not benefit from either of these, but their landlords do.  That is the reason for the saying "whether you rent or buy, you pay for the house you occupy."  Tenants pay for the home for their landlord.

Rent		Own
$2,500	Rent/Payment	$2,232
-0-	Principal Reduction	$504
-0-	Appreciation	$875
-0-	Estimated Monthly Maintenance	$300
-0-	Estimated Homeowners Association Fee	$25
$2,500	Net Monthly Cost of Housing	$1,178

*Projections based on 3% appreciation; $350,000 sales price with 10% down payment and a 3.5%, 30-year mortgage.

With each payment made on a fully amortized loan, the principal balance is reduced.  While appreciation is generally expressed in an annual rate, homes go up in value incrementally throughout the year so considering the monthly appreciation is appropriate in this comparison.

In this example, the payment is less than the rent proving the initial idea that it costs less to own a home.  After factoring in the effect of the principal reduction and the appreciation, even when you consider the maintenance and HOA fees, the net monthly cost of housing is considerably less than renting.

The largest part of the savings inures to the equity of the home which directly impacts a homeowner's net worth.  While the money may not be easily accessed, it has real value and available in a cash-out refinance or when the home is sold.

If you curious about how your numbers would be reflected in a similar comparison, go to the Rent vs. Own.  Please let me know if you have any questions.