I had a few people come over and hang out a bit on Christmas, and one of them is my ex-DJ friend.
He’s been keeping an eye on condo prices since his divorce, when he and his ex-wife sold the house. But condo prices in the areas he’d be interested in are way too much — especially with the current 7% interest rate.
So we were laughing about how he keeps seeing articles asking real estate agents when the best time to buy a home is. Because every time, the answer is “Anytime. Any time is a good time to buy a home.”
And of course, they usually cite “building equity” as a big reason to do so.
I rolled my eyes so hard that I almost sprained something.
The ole’ equity chestnut
This is hardly a new argument for homeownership.
While I’m not paying as much attention to the personal finance blogging/social media community, I’m betting the majority of PF “experts”* are still proselytizing homeownership.
Specifically, they like to say that renting is practically throwing away money. Why pay a landlord when you can pay yourself?
“Equity, equity, equity!” they cry.
And folks, that’s simply not a good argument. Why, you ask? Well…
* Often self-appointed, of course.
Equity is a buzzword
A friend once told me that a buddy had just bought a home and was nagging him to buy. Because he could be building equity. Instead of throwing away money, he’d have more equity!
After hearing this several times, he turned to his friend and said, “Okay, can you tell me what equity is, exactly?”
His friend had no answer. He not only bought a home, but also urged other people to buy a home, citing something that he didn’t actually understand.
And that’s less surprising than it should be. Because equity is thrown around a lot as a good thing — especially by banks and real estate agents. But they don’t really go into detail.
Instead, we just hear over and over and equity is good and desirable and part of homeownership.
So what is equity?
I’m guessing most of you know, but for anyone who’s only heard the term: Equity simply refers to the difference between your mortgage balance and the assessed value of your home.
Which means that equity has no inherent value. It’s something you can use, which may come in handy, but mostly “equity” is just an abstract idea.
And whenever possible, it should really stay that way
What can equity do for you?
Equity it’s really only used in three situations:
- When you sell your house, at which point “equity” becomes “profit.”
- Getting your bank to take off the private mortgage insurance (PMI)
- Home equity lines of credit
Selling your house
This one seems like a no-brainer, right? The more equity you have, the more money comes from the home sale.
And this used to (kinda)* make sense because, for a long time, there was the “starter home” model.
Couples (or individuals in general) would buy a home earlier on by choosing a smaller, more affordable house. One that was sufficient for two people without too much stuff.
The idea was that they’d wait for their salaries/equity to increase and then buy a bigger home that would fit a family.
So in that sense, equity was useful. But things have changed.
With house prices rising in leaps and bounds, a lot of homeowners — especially Gen Z and Millennials — plan to stay in the first house they buy.
Honestly, this makes a lot of sense.
Even a modest home can be a strain on finances these days. Plus, the decades-long wage stagnation in so many industries means that they can’t count on their salaries increasing appreciably.
So they decide to be happy with whatever house they can actually afford.
Obviously, there are instances where people move to another city/state, requiring them to sell their place. And of course, with the death of a relative, equity will mean pure profit.
But by and large, equity from home sales just doesn’t apply to a large swath of homeowners. Which means it wouldn’t applying to most renters — even if/when they do buy a place.
* I never understood being okay with paying thousands of dollars for agents’ commissions and various fees, probably only just getting to the point where mortgage payments aren’t mostly covering the interest and then… go through/pay it all again a few years later.
Private mortgage insurance is automatically added to mortgages that don’t have a 20% down payment. It’s kind of a side bet for the bank, just in case you default.
And with the U.S. median home price hovering around $400,000, almost no one has a 20% down payment anymore. So most homebuyers are stuck paying $100 to $200 (or more) just for the privilege of having the mortgage they also pay.
You can ask the bank to remove the PMI once your mortgage is down to 80% of the purchase price (or assessed value, if you go for a new appraisal). And it will be removed automatically once you hit 78%.
So in this case, equity is quite useful… to current homeowners.
But renters already don’t pay PMI. So… it’s not an argument for buying a home. If anything, it’s an argument against purchasing a place.
As a loan
Ultimately, the real “value” of equity is through home equity lines of credit (HELOCs).
This is usually what banks/real estate agents are talking about when they extoll the virtues of building equity.
Think of a HELOC as a revolving line of credit, similar to a credit card but with a much lower interest rate.
As with a credit card, you don’t actually have to use the credit limit at any given time. (Though some banks charge inactivity/maintenance fees, so read the fine print.) But it’s there if you want to take it out.
If you do, the bank will start requiring a monthly payment, just like using a credit card. Except it’s far more affordable to not pay the whole amount right away.
That sounds good, right? But…
Justifications for HELOCs
One argument is that HELOCs are great in the face of large unexpected expenses. Again, it’s far more affordable to have a HELOC balance than a credit card one.
Not the worst reasoning, though also not the best. I’ll get into that further down.
The thing is, HELOCs are routinely mentioned as a way to afford optional expenses like expensive upgrades and renovations.
People are encouraged to tap their equity for those expenses rather than change the scale of renovations to multiple, smaller projects. And they’re often reminded that upgrades/renovations will probably increase their home value, meaning more equity. That’s it basically all evens out.
Of course, the increase in home value only matters if they sell — but somehow that part gets left out of the pitch.
And it used to be much worse. During the housing bubble, people were using HELOCs to afford expensive toys (think extensive home entertainment system or even Ski-Doos), car down payments or even family vacations.
Somehow I doubt that many homeowners came up with that idea themselves.
HELOCs: Just say no
Point being, HELOCs can be a more affordable way to cover large expenses. But there’s a very big reason to find another way. And that’s the colloquial name for HELOCs: second mortgages.
That’s because, just like regular mortgages, your house is being used for collateral. Which means that, just like a regular mortgage, you can be foreclosed on for not making payments.
So let me say it again for emphasis: You can pay your mortgage on time every month, but if you can’t make your HELOC monthly payments, you could still lose your house.
Let that sit for a minute. Then ask yourself if a mind-blowingly gorgeous kitchen is really worth more risk of losing your house.
So if an expense comes up that that a saving account can’t cover, it’s much safer to apply for a personal loan. Even if the rate is higher, at least it doesn’t endanger your living arrangements.
And failing that, you can always try to get a low- or 0% interest credit card and charge the expense to that.
Speaking of credit cards, there’s another way people use HELOCs.
Equity to fight debt
Sometimes HELOCs are used to pay off credit cards and consolidate the amount to a much lower rate.
And if you don’t have my levels of anxiety, I suppose this makes sense.
But there’s still the fact that credit cards/other loan debt, doesn’t increase your chances of losing your house.*
It’s easier (or at least better) to go for a debt consolidation loan or — in extreme cases — try for debt settlement. Or a regular personal loan. Or a low interest credit card with reasonable balance transfer fees.
Because bad habits might flare up again or perhaps circumstances — layoffs, big (necessary) expenses, etc. — will conspire to mean you can’t keep up with the payments.
Probably not, but life is unpredictable sometimes. And once it a while, it likes to really pile up on us. (Remember my 14 months of financial pain?)
In the end, it’s better to risk your FICO score than your residence.
* Other than maybe student loans, where your wages could get garnished, potentially making it harder to pay the mortgage.
For all of these reasons, and probably more, arguments using the “equity” crutch should be taken with a grain of salt. A large one. Maybe a small salt lick.
Because, while not a bad thing in and of itself, equity helps convince a fair number of people to take out hundreds of thousands of dollars that they might not have done normally. That it is, in fact, the only smart move, regardless of how much financial strain results.
And that is a very bad thing.
What do you all think about equity as an argument for homeownership? And about HELOCs?