Realtor® Speak 101: Home Equity
What is home equity?
In covering some recent topics, such as yesterday’s post about the new proposals for changes to FHA loan guidelines, I’ve been talking a lot with people about home equity and thought I’d take a few moments to explain and show how equity works in relationship to your home.
The chart to the left will be used to illustrate the effects of different factors on your home equity (sorry it’s not a very cool looking chart, I never was much of a graphic designer). As you can see the red color on the graph represents the “amount you have paid on your home loan” and the green color represents the “amount you still owe on your home loan.” The red color is your home equity and the green coloris your debt (in this case, your mortgage).
Let’s set up an example so we can toy with the numbers. You’ve just bought a house (today, December 5, 2009) for $100,000. Your loan required a 20% down payment ($20,000), so you only borrowed 80% of the value of the home ($80,000). It’s a 30 year mortgage with a 5% fixed interest rate.
In our first example (see the graph above), we’ll keep things simple and ignore appreciation and depreciation. Let’s just pretend that you home will never increase or decrease in value over the 30 year span of your loan. It’s worth $100,000 today and will be worth $100,000 in 2039. The day you bought the house, you paid $20,000 as a down payment. On your first day, this is the value of your home equity. If you sold the house today for $100,000 (its value), you would owe your lender $80,000 for the loan and would keep $20,000 for yourself. Of course, you would never sell the home on your first day as that $20,000 in equity would also have to be used to be for closing costs and Realtor® commissions. Plus, you just moved in and you like your new place.
Since you borrowed $80,000 from your lender at 5% interest for 30 years, your monthly payments (not including property taxes and hazard insurance) would be $429.46 (you can figure this out using an amortization schedule, which I will explain in a future post). So every month you pay your mortgage and all is well in your life.
The way home loans are structured, your first few payment are mostly interest (your first payment is $333.33 in interest and only $96.12 in principal). As the years pass, this balance begins to tip towards more principal and less interest (your final payment in 2039 is only $1.78 in interest). In order to reach 50% equity ($50,000) on this home (as illustrated in the graph above), you would need to wait until September 2026. This means that if you sold your house in September 2026, you would pay back the bank their loan and receive $50,000 (remember we’re assuming no appreciation or depreciation in your home’s value). Once again your closing costs and Realtor® commissions would come out of that $50,000.
As you can see, it takes a long time to build up home equity just through normal monthly mortgage payments because of the way principal vs. interest is paid out of your monthly payment. Of course, this example didn’t have much in the way of real life application as we didn’t account for appreciation and/or depreciation. Tomorrow we will take a look at the two and see how they can affect our home equity.
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« An Open Letter To HUD About FHA Loans | Home | Realtor® Speak 101: Appreciation and Depreciation – Home Equity Part II »
Comments
Thank you for this first time buyers should be recommended to read this post. There are alot more complications when going into a mortgage as many people already know there are benefits at the end of the process but you know as soon as you miss a payment there are many more issues that will accure.
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