Home equity relates to real property ownership. Sophisticated investors often leverage home equity, in order to compound additional wealth. Strong property values, in conjunction with regular mortgage payments, work to establish home equity. All real estate purchases, of course, introduce distinct risks, which may result in an upside-down mortgage, or negative equity situation. Negative equity is often a prelude to property foreclosure.
Define Home Equity
Home equity is defined by financial ownership, and subtracts your mortgage balance from your home’s property value. Home sellers should expect profits to approximate the home equity amount. Home equity is often a major component of total net worth, which subtracts away total liabilities from total assets. Home equity, however, may not be categorized as a liquid asset. Liquid assets, such as certificates of deposit, stocks, and bonds, are financial securities that may be quickly converted into cash.
Mortgage amortization increases home equity. Mortgage amortization is the technical term to describe the process of paying down housing debt. Monthly mortgage payments go toward reducing principal and meeting interest expenses. Mortgage principal refers to the balance owed, while interest payments compensate banks for making loans. In the early years, interest charges account for the majority of home loan payments, while mortgage principal declines relatively gradually. Over time, monthly mortgage payments build home equity at an accelerated pace as smaller principal balances obviously carry reduced interest charges.
Real Estate Markets
Property value appreciation also creates home equity. Strong property values are a function of heightened real estate demand alongside a limited supply of housing. Downtown areas and other densely populated neighborhoods typically sustain high real estate values, because land is relatively scarce. In terms of demand, a strong economy that creates jobs increases the need for housing. Access to infrastructure can also improve real estate demand. For example, property values alongside a proposed freeway right-of-way should improve as the road opens for traffic.
Professional appraisers evaluate comparable, or comp, sales figures when calculating property values. Homeowners can apply similar techniques to track recent sales within an immediate neighborhood and estimate current home equity. Local circulars are an ideal reference points for recent real estate activity.
Strong home equity improves chances for applicant loan approval upon good terms. Lenders may ask whether the home is owner occupied and verify this information through credit reports and proof of residence mailings. Timely mortgage payments signal one’s ability to build wealth and responsibly manage debt.
Home equity may serve as collateral to back other forms of credit, such as home equity loans. These collateral terms lower financial risks for banks, and allow applicants to negotiate relatively low interest rates for home equity loans. Home equity loan terms introduce distinct risks, because terms of these agreements do allow banks to foreclose, or seize, property to make good upon any missed payments.
Recession and weak real estate markets often precipitate upside-down, or negative equity, situations for homeowners. At that point, mortgage balances are actually higher than home property values. Chances for foreclosure increase, because owners would then be unable to sell homes for enough cash to pay off the outstanding mortgage principal. A distressed homeowner may work out a short sale arrangement, where the bank willingly accepts less cash on the home sale than was owed upon the mortgage.