Home Equity: The Lessons We Learned

Home Equity Truth

We want to give you an adjustment. The adjustment is with your understanding of home equity. You see, many of us have been led to believe one thing about home equity when the reality is acutely different. This misinformation, if not an outright lie, puts you and your family in a precarious situation that could lead to financial disaster.

Heads on Backwards?

As we know too well, housing madness was the bubble de jour heading into 2008. The term irrational exuberance was coined, in part, because of a faulty premise. Many considered real estate a surefire investment, a commodity that only appreciated. Mid-day and late night television was deluged with house flipping and get-rich-quick real estate infomercials. Everyone and their grandmother were in on the fix and flip craze. Overnight managers became construction experts and stay at home moms became premier interior decorators, both of whom it seemed could do no wrong.

The construction was mediocre and the interior designs just various shades of beige. It was brilliant. Put $20,000 down on a $150,000 house, slap on some paint, a couple of new doors, new cabinets and the same granite counter top everyone else had and voila! The remodeled house sold for $250,000 and the “investor” walked away with $30,000 to $50,000 in profit for a few months worth of work.

It was a brilliant mistake because everyone was playing the real estate game. Everyone qualified for a loan. Pre-qualification loans were handed out like free samples at Macy’s. Recent college graduates with new, $40,000 annual salaries were given $400,000 mortgages. Everyone, especially real estate agents, bankers and mortgage brokers received mammoth paychecks. In this perpetual appreciation market, if you bought a house you couldn’t afford, you just lived in it for six months and then pulled out the equity to buy a house you could afford. Well, that never happened. People just traded up. Everyone thought they were the winner.

Only One Winner

With the exception of pee-wee soccer, in every game there’s only one winner. Who is, was and will always be the winner in the game of real estate? It’s always the entity that owns the house.

Who owns the house? Wrong. It’s not the person who built it. It’s not the one who signed on the dotted line to buy it. It’s not the person who makes the payments. It’s not the one who painted it or planted the sod and flowers in the front yard with the new sprinkler system. The owner of every house is the one who possess the title. The majority of titles are held by banks. That’s right; the bank owns your house. As with a stock, you don’t own your house until it’s paid for in full.

We know it’s a bit off kilter to say that the bank owns your house when you put down 20 percent and have made payments for 10 years, but it is true. As with every business partnership, the part of the business you own is negotiated. If you went into a 50/50 agreement then you own 50 percent.

Also Read: 3 Money Magic Tricks 

How much of your home do you own? In most cases, especially after the exuberance to buy more than one could afford in the mid-2000s with a zero percent down or interest-only loan, most don’t own more than 5 to 20 percent of their house. Fact; the bank lets you borrow their house until you pay for it in full.

That’s Right the Equity Isn’t Yours, Either

By now, most of you have said, “That’s wrong!” We wish we were. Ask yourself this question. If you own something, must you pay a fee to use it? Do you pay a usage fee for your car? Do you pay a usage fee to put on your clothes in the morning or when you open your fridge to get food? Of course you don’t. You paid for those items in full. You are the owner. Why would you pay a fee?

If you own the equity in your house, can you use it without paying a fee? Of course you can’t. What happens when you withdraw equity on your house to remodel the bathroom or finance your kid’s education (something we strongly discourage)? Because you don’t own your house, you pay a usage fee to use its equity. You go to the bank, you get a home equity loan and you make payments back to the bank to borrow on something they own.

By now some of you have said, “If I want I can sell my house and pay off the loan or my bank can foreclose on me and I will get a check for any equity.” That’s correct, but what happens in both transactions? The bank is paid in full for their portion of the business partnership. You don’t get yours until they get theirs because the bank possesses the title and is the owner.

More evidence focuses on the title. If you concede that the bank is the owner because they are the largest shareholder of your house, why don’t they send you the title when you become the larger shareholder? This is because the game is designed so they maintain ownership of the property until the property is paid in full.

We will grant you this. You own a portion of the equity in your house. See the following example.
Example: We sign the mortgage for a $150,000 house. We put 3 percent down and the bank takes a (poor) risk and loans us 97 percent. Over four years, the house appreciates 2 percent annually and is valued at $162,000. Additionally, we have a principle balance of $138,500. That’s right, $850 a month in payments over four years pays down $11,500.

What is our percentage ownership of the house and thus our percentage ownership of the equity?  The equity in the house is $23,500 ($162,000-$138,500). Based on the original agreement of $150,000, the bank owns $138,500 and we own $11,500 of the house. The split is roughly 92 percent/8 percent. That equates to a whopping $1,880!

What’s the Lesson?

Our goal isn’t to make you think you house is worthless. Our goal is to help you take a money conscious perspective of real estate financing. With an accurate financial picture, you can make accurate financial projections and plans that reduce your risk of financial ruin.

Here are our three tips to become a money conscious homeowner:

  1. Don’t buy a house worth anymore than three times your household income.  Just because the bank says that you can afford $400,000 doesn’t mean that you should buy a $400,000 house. This will make mortgage payments manageable and let you make larger monthly principal payments.
  2. Save up the money and put down a minimum of 20 percent of the purchase price of the house. There are two advantages with this tip. First, this will give you a lower interest rate because you have a larger share of ownership that makes you a better risk to the bank. (Check out this great article.) Second, you won’t have to pay for PMI (Private Mortgage Insurance), which is required for those with less than 20 percent ownership in their house. This savings can be used to pay down principal.
  3. Make extra payments towards your mortgage principal. We did this and refinanced for a better rate and a shorter term that will save us $95,000 compared to our original mortgage. Make sure the extra payments are put towards your principal. Even $25 extra a month has an impact. If you get paid weekly or bi-weekly, make payments based on your pay schedule to make 13 mortgage payments a year instead of 12. When you have extra money, whether from a bonus, windfall or gift put it towards your principal.

Home ownership has many benefits and seeing the value of your house increase lets you know you made a good decision. Keep in mind, though, that you don’t own your house until you actually own your house. Don’t make risky decisions with something that can easily disappear or be taken away. A mortgage is an agreement with a bank and until you own your house in full the bank has the reins to control the relationship. The sooner you take control, the better for your #MoneyConscious life.

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Comment List

  • Kyle 31 / 07 / 2015 Reply

    While I fully agree with the idea behind ‘don’t buy a house worth more than 3 times your salary’….what would you say to those who live in areas where there are no houses in such a range. I live in a town of 100,000 in southern ontario and our house prices are starting at 300K. The only houses under are at about 250, and need 50 K of work min. So does one just continue to rent while others make the money and their portion of the equity off of my payments each month?

    • David Auten 02 / 08 / 2015 Reply

      You are absolutely right. Not everyone is swiming in the same water. I have two questions, what kind of living conditions do you really need and how flexible are you? The response here is much more than what we have space for and a good follow up article, but here are a few thoughts. 1. Every market has the undesirables, can you buy one of those and fix it up to a “livable” state so you can then save for the home you truly want? 2. Can you downsize your current renting situation so that you can bank a much larger down payment (this has a huge impact on what you can afford) since 3x your salary is a general rule? 3. Maybe Ontario is not the right choice for you? We know someone who downsized and moved to a house in another town so that she and her husband could invest more heavily towards their retirement. It wasn’t an easy choice, but looking back it was the right one.

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