Equity

When someone buys a new home, equity is the cash down payment—the funds that the home buyer invests—to purchase it. The sum of equity and the mortgage(s) totals the purchase price of the home, including all closing costs. If the market value is greater (or less) than the purchase price or the price as the home appreciates over time, then equity is equal to the current value of the home minus all claims against it.

[Page 192]The fundamental relationship between mortgages, which are loans collateralized by property (L) and equity (E), is L + E = V where V is current market value. Lenders utilize a loan-to-value ratio (L/V) to determine how large a mortgage a borrower can obtain. The sum of the L/V and the equity-to-value, or E/V, ratios equals 1. Therefore, if the L/V ratio is 75%, then the equity would be 25% of the market value of the home. The L/V ratio is called leverage. As the ratio increases, leverage is said to increase, and the equity is reduced.

Where the owner has a self-amortizing mortgage on the home, she or he gradually pays down the remaining balance on the mortgage through the monthly debt service. The paydown increases the equity of the owner in the property. This is referred to as equity buildup. When the mortgage is fully paid off, and assuming there are no other outstanding debts or claims, then the equity would be equal to the full current value of the home. On fully amortizing mortgages, this may not occur for 20 or 30 years.

While property owners can receive back all their equity when they sell the home, they are able to borrow against their equity by utilizing home equity loans. The first type of home equity loan, also known as a second mortgage, gives the owner a lump sum of money that must be repaid over a fixed period, similar to the first mortgage. The second type is a home equity line of credit, which gives the owner the ability to borrow funds secured by the home. Unlike the home equity loan, the line of credit is similar to a revolving loan that can be paid down and later increased. Interest is paid on the balance of the line of credit.

Owners may have multiple mortgages on a home. The value of their equity is equal to the current market value of the home minus the sum of the remaining balances on all the mortgages. Equity is further reduced by liens such as mechanics liens (unpaid workmen and suppliers) and tax liens (unpaid property taxes).

During the financial crisis of 2008 to 2010, home values dropped by 30% to 50% or more in many places leading to negative home equity. This means that homeowners’ outstanding mortgage balances exceeded the value of their homes. A major issue in the financial crisis was how to save homes with negative equity from going into foreclosure. Lenders have been reluctant to restructure the mortgages by reducing the amount of the principal balance or the interest rate to a level the borrower can afford, because such write-downs affect the lenders’ capital requirements.

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