Should Families Buy a House or Rent an Apartment: Why Home Equity is Overrated

Mortgage

Mortgage (Photo credit: 401K)

My first post in this series was about how home ownership is more risky than renting, although less risky than most people give credit. My second post was about how the “hidden” costs of home ownership are overstated by pro-renting proponents and that ownership is cheaper than renting regardless of maintenance and replacement. This series isn’t just about settling the debate on misconceptions from those favoring renting; it’s about settling misconceptions that arise from ownership proponents too. One area that is often overrated by personal finance bloggers is home equity.

Home equity is the value of your home that you could turn into cash if you were selling. More simply, people like to assume that it is the price you could sell your home for minus the principal you still owe on your loan. While this simple calculation is an easy and useful way to assess home equity, it will overstate the value of equity you really control.

Benefits of Home Equity

As my title indicates, in general people overrate the actual value of their home equity. However, there are some very unique, non-monetary benefits to home equity. Few assets can offer these kinds of benefits.

  • Increases your credit score
  • You can use equity without selling (example: use equity as collateral for a loan)
  • Increases your net worth
  • And equity often keeps pace with inflation through housing market appreciation

Few investments can offer similar benefits. However, though these are very useful benefits, home equity is almost always overrated by home buying proponents.

What’s the Value If You Don’t Use It?

You may have a home worth $250,000 and on paper, that value can really make your net worth appear impressive. However, what if you own your home until you die?

My great grandfather owned his house for over 50 years and when he passed away, the equity went to his survivors. In the grand scheme of things, equity is the last source of net worth you will likely tap. Sure, it’s nice to have, but then what are the odds you are ever going to use it?

It Costs Money to Tap Into Equity

Home equity is a paper tiger unless you plan on tapping into it and when you do, it costs money.

If you are going to sell your home it will likely cost at least 6% in selling commissions to your realtor; more if you consider some of the costs of closing.

Perhaps you plan on taking out a reverse mortgage instead? Then you’ll be paying interest on the property all over again. Also, the bank is not going to let you tap the full value of your equity; you’ll have to maintain a certain percentage so that there is a cushion when it comes time to sell.

Downsizing might be even worse. You’d be paying the same costs to sell, plus the new costs to buy another home. Finally, a portion of your home equity will be tied up as equity in a smaller home.

Home Equity is an Accounting Number, Not a Check

Ultimately, the problem of using and cashing in on equity is that the amount of equity you have is a factious number until you try and exercise it. When you do, the number is always much smaller. It’s an important distinction to understand,  especially if you are trying to evaluate alternative investments to home ownership.

Having home equity is better than not having home equity. However, every time you assume your home’s market value as the equity you command you are overestimating your net worth. Unless of course you don’t plan on using your home equity in which case, home equity adds nothing to your net worth.

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