Realtor® Speak 101: Appreciation and Depreciation – Home Equity Part II
Your home equity and fluctuations in the market.
As you may remember from yesterday, we were discussing home equity and how it works. Today we will take on appreciation and depreciation and its effects on home equity. Let’s start with some definitions, shall we? Appreciation is defined by Merriam-Webster Online as “increase in value.” Depreciation is defined by Merriam-Webster Online as “to lower the price or estimated value of.”
We’ll be working off of the same example as we did yesterday to keep things simple. Please remember, that these numbers were used to keep things simple; mortgages, the real estate market, home equity, appreciation, and depreciation would not necessarily be as simple as this in real life situations. If you need help with more complex home equity calculations, feel free to contact me or a local San Antonio lender. As a refresher, here’s the terms of our example:
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.
As before, 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.”
Your home equity is growing.
Appreciation occurs when your home’s fair market value is greater than what you paid for the home. Appreciation can occur for many reasons; natural fluctuations in the real estate market, upgrades, repairs, additions, neighborhood conditions and improvements…a whole host of things can affect your home’s fair market value. Now, let’s take a look at appreciation as it relates to our example.
The new blue color on our graph represents your home’s appreciation in value. Let’s assume that the day after you bought your home, San Antonio announced a major development in your neighborhood that makes your home more valuable. Your home has appreciated. In the graph above, your home has appreciated by 10%. Since you bought the home for $100,000, this would make the home worth $110,000 now. You still owe the bank the $80,000 you borrowed and you used $20,000 for your down payment. Your home equity was $20,000, but because of the recent appreciation, your home equity is now $30,000 (appreciation plus current home equity). If you sold your house today (for the new fair market value of $110,000), you would pay off the balance of your loan ($80,000) and retain $30,000 (don’t forget there are costs associated with selling your home such as closing costs and Realtor® commissions).
Uh oh, your home equity is shrinking.
Depreciation is a loss in value of your home and affects home equity negatively. Much like appreciation in your home’s value, depreciation can be caused by many factors; natural fluctuations in the real estate market, wear and tear on the home, and obsolescence are the three best examples of depreciation of a property.
Returning to our graph (above) you can see that the new orange color represents your home’s depreciation. Still using the same example, let’s assume that the City Council of San Antonio just approved a small toxic waste dump in your area. Obviously, no one wants this to occur near their home and the consequences would be a devaluation of your home – depreciation. In the graph above, your home’s value has dropped by 10% or $10,000. Since you paid $100,000 for the home, 10% depreciation would leave your home at a fair market value of $90,000. We still have the outstanding $80,000 loan balance, so our effective home equity would be $10,000 (price paid for the home minus the loan balance minus any depreciation equals your home equity). This is exactly what we hope won’t happen to our homes – it’s always better to appreciate (and increase the equity in our home) than to depreciate (and decrease the equity in our home), but as we’ve seen recently – it can happen.
I hope you enjoyed this look at home equity in terms of appreciation and depreciation. If you have follow up questions, feel free to comment below or contact me.
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