Future home equity gains from amortization rather than appreciation
When mortgage rates are low but rising, equity growth comes through amortization rather than appreciation.
Equity is the cash value stored in a owner’s house. Many people assume equity is the difference between what a house is worth and what they owe on it, but this overstates the reality by 8% or more of the estimated value because if a homeowner needed to convert the house to cash, they would need to sell it, discounting the property from their perceived value and incurring fees and costs in the process.
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.
For purposes of illustration, equity can be broken down into several component parts: Initial Equity, Financing Equity, Inflation Equity, and Speculative Equity.
- 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.
- Speculative Equity 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 down payment, the amount of owner’s equity is the combination of the above factors.
The initial equity is equal to a purchaser’s down payment. If a buyer pays cash for a home, all equity is initial equity. Since most home purchases are financed, this initial equity is usually a small percentage of the purchase price, generally 20%, but with FHA loans, it can be as little as 3.5%.
It’s worth noting that since it costs a seller about 8% to liquidate real estate, this 8% of a buyers down payment is “lost” at the closing table, similar to the instant depreciation a car owner experiences when they first drive off the lot. While most FHA buyers would tell you they have 3.5% equity in their property, they couldn’t sell it and get that money back out, so they really start 4.5% underwater.
A down payment is the borrower’s money acquired through careful financial planning and saving or from the profits gained at the sale of a previous home. Down payment money is not “free.” This money generally is accumulated in a savings account, or if a buyer chooses to rent instead, down payment money could be put in a high-yield savings account or other investments. There is an opportunity cost to taking this money out of another investment and putting it into a house. (See: What don’t buyers invest in when they make a down payment?)
Financing equity is determined by loan terms. With a conventionally amortizing mortgage, a portion of the payment each month goes toward paying down the loan balance. As this loan balance decreases, the owner’s equity increases. This is a substantial long-term benefit of home ownership.
With an interest-only mortgage, the loan balance does not decrease because only the interest is paid with each payment; thus interest-only loans accumulate no financing equity. Since financing equity fails to accumulate, borrowers saddled with these loans obtain less equity in a sale over time, and they find it far more difficult to execute a move-up trade.
Over the short-term, financing equity is not significant because the loan balance is not paid down by a large amount, but if the house has been held for 10 years or more, or if the loan was amortized over a shorter term, the financing equity can be a large amount, adding to the total equity amount put toward a larger, more expensive home. Also, financing equity is a great reservoir for retirement savings; in fact, it’s the primary mechanism for retirement savings of most Americans.
Financing equity was so insignificant during the housing bubble, most borrowers thought it irrelevant. Going forward, it will become the most important feature of a borrowers equity accumulation strategy.
House prices historically have outpaced inflation by 0.7% nationally. In a normal market, this is the only appreciation homeowners obtain. This appreciation is caused by wage inflation translating into higher housing payments and the ability of borrowers to obtain larger loan amounts to bid up prices. In California where wage growth has outpaced the general rate of inflation, the fundamental valuation of houses has increased faster than inflation; however, after 25 years of above-average appreciation due to falling mortgage rates, and with houses 30% overvalued relative to income, the math favors 20 to 30 years of below average appreciation while fundamentals catch up.
The related benefit to home ownership obtained through utilizing a fixed-rate, conventionally-amortizing mortgage is mortgage payments are frozen and the cost of housing does not increase with inflation. Renters must contend with ever-increasing rents while homeowners with the proper financing do not face escalating housing costs.
Over the short term this is not significant, but over the long term, the monthly savings accruing to owners can be very sizable, and if the owner owns long enough or downsizes later in life, housing costs can be nearly eliminated when a mortgage is paid off (except for taxes, insurance and upkeep.)
Although this benefit is attractive, it is not worth paying much of a premium to obtain. The long-term benefit is quickly negated if there is a short-term additional cost associated with obtaining it. For instance, if a property can be rented for a certain amount today, and this amount will increase by 3% over 30 years, the total cost of ownership — even when fixed — cannot exceed this figure by more than 10% to break even over 30 years. The shorter the holding time, the less this premium is worth. In short, capturing the benefit of inflation equity requires a long holding period and a minimal ownership premium.
Speculative Equity is purely a function of irrational exuberance. A common element in California real estate markets markets, capturing speculative equity is the dream of every Californian who buys residential real estate. As noted in Speculation or Investment? it’s often a losers game, but it does not stop people from chasing after it.
The passage of Dodd-Frank and the establishment of the qualified mortgage and ability-to-repay rules, future real estate market action will be far less volatile. Less volatility means less speculative equity.
Lower Prices or Lower Rates
Based on what I described above, which is better for accumulating equity, lower prices or lower interest rates? Both lower the monthly cost of ownership and result in more disposable income. Obviously, the banks prefer higher prices to recoup their capital from their bad bubble-era loans, so they are offering 4% interest rates to prevent prices from going any lower. I think most buyers would prefer lower prices, but since the banks make the rules which determine market prices, low interest rates and high prices are what we get.
From a homebuyers perspective low rates or low prices depends on how they acquire the property. All-cash buyers would far prefer lower prices because they gain nothing from cheap debt they don’t use. From a financed buyer’s perspective, lower interest rates are better even if they pay higher prices.
If a financed buyer holds a property for 30 years and pays off the debt, how they financed the property doesn’t matter; however, if they sell the property before paying it off entirely, low mortgage rates are superior because they amortize faster. Assuming equal rates of appreciation during the holding period, a financed buyer using a low mortgage rate will accumulate more equity than a buyer who pays a higher mortgage interest rate; that’s the math. The key question is whether or not appreciation rates would be the same.
Buyers who purchase during a period of high mortgage rates may get the boost in appreciation from declining rates, so they may enjoy more appreciation than a financed buyer who buys today when mortgage rates are low. Over the last 30 years, declining mortgage interest rates added significant appreciation above and beyond the growth in income; today’s buyers won’t get the same boost.
Low mortgage rates build equity faster through amortization but slower by appreciation. High mortgage rates build equity faster by appreciation but slower through amortization.
Since we are in an environment of low rates that are likely to rise, going forward, more equity will accumulate by amortization than appreciation — assuming homeowners don’t spend it.