Equity is the difference between the market value of your home (what it could sell for) and the amount you still owe on your mortgage. Home equity can change in two ways: either through changes in the market or through changes in investment in the home to impact the loan balance. Home owners always hope for appreciation in their market value to drive equity up.
However, with the real estate crisis of 2008 and the following financial recession, many home owners saw their equity go down as market value declined. As many as 26 percent of mortgaged properties had negative equity in 2009, meaning that home owners owed more on their loans than the then-current market value. Since then, CoreLogic’s Q4 2016 mortgage analysis indicates a substantial recovery, with 93.8 percent of homes with mortgages now having positive equity.
What makes home equity go down?
The expression “what goes up must come down” usually doesn’t apply to real estate value and home equity. Nevertheless, specific changes by home owners or external changes in the market can cause equity to drop.
Consider these possibilities for a decline in market value:
- Low “comps.” If comparable properties in the area are not attracting desired prices, the market value appraisal will reflect these lower values.
- Home condition. A run-down, old-looking home is valued lower than a well-maintained, attractive property with modern appeal.
- Neighborhood appeal. Neighborhoods may be less attractive and lose market value for reasons such as declining school reputation or loss of specific amenities.
- Glut in the market. If the supply of homes in a given neighborhood exceeds the demand, prices will drop.
Home owners can help prevent the decline of their own property with maintenance and upgrades. While they cannot generally have as much impact on their neighbors’ properties and the neighborhood itself, participation in home owners associations (HOAs) and community development projects may help to address broader problems. Sometimes waiting out a market glut or looking for seasonal demand can allow the home owner to get a higher price.
Home equity will also be reduced by raising the loan balance across all home-related loans. This may happen if the home owner
- refinances the mortgage for a higher amount
- takes out a home equity loan
- activates a home equity line of credit (HELOC)
- pursues a reverse mortgage
The first three loan situations are set up so that the home owner will resume increasing equity with payments on the loans.
What makes equity go up?
A home owner can increase market value by making improvements to the home, but the value retained at resale generally isn’t 1:1. Remodeling Magazine provides a helpful report of cost vs. value for numerous projects ranging from attic insulation and door replacement to kitchen remodels and additional stories. The National Association of Realtors recommends improving curb appeal not just for the impact on market value, but also to get more people in the door to see the property.
If the market value stays the same, payments toward the loan will generally increase equity. Keep in mind these situations:
- Some loans are amortized with higher interest payments and lower principal payments up-front so equity increases slower early in the loan than later in the loan.
- If allowed, extra payments such as biweekly rather than monthly can be applied to principal, increasing equity more quickly.
- Paying off a shorter-term loan (e.g. 15-year) will build equity faster than a longer-term loan (e.g. 30-year).
- Required payments on an “interest-only” loan will not increase equity, although extra payments may be allowed to go to principal.
How do market interest rates impact equity?
Mortgage interest rate changes can affect the size of a mortgage that a buyer will qualify for. A buyer is pre-qualified for a loan with a given monthly payment. When rates decline, buyers can buy “more house” for a given monthly payment. In addition, more people at lower income levels will be able to enter the home buying market.
When the interest rate goes up, the monthly payment goes up. If this causes the payment to rise beyond the pre-qualification amount, the loan will not be allowed.
Often, changes in interest rates can be as small as 0.5 percent. That one-half percent interest change may seem quite small, but its impact can be large. For example, with a fixed-rate mortgage of $100,000 at 4 percent for 30 years, a home owner will pay $477.42 monthly, but at 4.5 percent, payment increases to $506.69, with an increase of more than $10,000 paid in interest over the life of the loan.
When signs begin to indicate that the Fed is about to raise interest rates, the housing market often sees an increase in activity, with home buyers trying to beat the change in the rate. Home sellers may offer incentives to help buyers make the purchase in order to have a faster sell, knowing that there will be a slight stall in buying immediately after the rate hike. This potential drop in market price corresponds to a decrease in equity.