Defining Home Equity And How It’s Created

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First, a definition:

(Home Equity) = (Value of Home) - (Amount Owed On Home)

There are two ways that equity is created:

1. The homeowner pays down the principal balance on the mortgage. 
2. The home's value increases because of appreciation

But just because both methods increase the equity position in a home, that doesn't mean that they're equal.  Quite the contrary.

Method #1: The homeowner pays down the principal balance on the mortgage. 

When a homeowner pays down a mortgage, he is using funds from a paycheck.  As all of us know, by the time we get our paycheck, the earnings have already been taxed by local, state and federal governments. 

Now, if the money was left in the bank, it would earn interest.  By contrast, once the money is withdrawn and used to pay down the mortgage, those interest payments are forfeited in favor of a 0.00% rate of return.  A home is not a bank account and it does not pay interest for making "deposits". 

Neither does a home make "deposits" readily available to its owner; if a homeowner wants to access a portion of their principal paydown, he is required to ask the bank for a remortgage.  Not only can the application be denied for a number of reasons, it can also take up to three weeks to process.

Method #2: The home's value increases because of appreciation

Equity is also created when the home itself creates value.  Looking back 100 years, real estate has appreciated so we should expect that it will continue to appreciate as a long-term investment.

As homes increase in value, homeowners benefit from additional "dollars-on-paper" and this is where building equity via appreciation really shines. 

When a homeowner sells his appreciated residence, he not only earns a profit for just having owned the home, but the profit from the sale may be 100% tax-free.

For couples filing jointly, up to $500,000 of gains from the sale will be exempt from taxes; for individuals, $250,000.  Check with your accountant to see how tax law applies to you personally.

So, not only is home equity an asset, it's an asset that may not get taxed.  Clearly, that's a huge advantage.

Now, this isn't to say that paying down your principal balance is a poor financial planning decision.  It's just to say that there may be smarter targets for your investable dollars. 

Paying down principal, after all, is not creating wealth -- it's just moving wealth from your liquid bank account to your illiquid house.

The only way that wealth is truly created in real estate is through home appreciation.  The home is the "thing of value", not the mortgage.

The mortgage is just the debt.