The paper by Beutler and Yorganson (1997)61 identifies several basic factors that influence home equity value. These factors include:
Home appreciation (or depreciation) refers to the increase or decrease in the market value of a home. This can be influenced by several factors:
Real estate is typically a leveraged investment, often purchased with significant debt (mortgage). This leverage can amplify returns but also increases risk. The appreciation in the property’s value is based on your initial downpayment, not the total home value. For example, with a 20% downpayment, a 5% increase in property value yields a much higher percentage return on your initial investment.
Debt leverage is a complex factor in home-equity preservation and accumulation, consisting of two core elements:
In favorable circumstances, long-term mortgage financing enables rapid home equity accumulation. Favorable leveraged circumstances occur when the home appreciation rate is positive, and the debt-to-equity ratio (D/E) ratio is greater than one. However, if the leverage multiplier is large, leverage can work against wealth growth when home prices depreciate, potentially leading to negative equity.
Residential real estate generally exhibits lower price volatility compared to equities, partly due to the slower, more bureaucratic process of buying and selling properties, and the essential nature of housing, which provides a stabilizing effect on your overall asset allocation.
The present value of all your future payments, discounted by the mortgage interest rate, equals your house price. Real leverage is realized only when house price growth exceeds either the mortgage interest rate or inflation. It is more sensitive to the difference between house price growth and inflation. Remember, you are leveraging through interest.
Home equity can also grow through principal payments as mortgage debt is retired. Debt on standard fixed-rate home mortgages is retired through amortized payments, which gradually reduce the principal outstanding and increase owner equity. Systematic equity accumulation through regular mortgage payments has been a significant wealth-accumulating and wealth-preserving avenue for homeowners in the United States, especially in the decades following World War II. Typically, young home buyers make a modest down payment on a starter home and then accumulate equity through regular monthly payments. This equity can later be used to purchase a more expensive home to meet the needs of a growing family or to achieve a higher standard of living. In later adulthood, mortgage-free home ownership contributes significantly to financial security.
While home appreciation, leverage, and principal payments may combine to produce positive equity growth in nominal terms, the rate of this growth needs to be adjusted for inflation to convert it from a nominal rate to a real rate. Nominal rates ignore the diluting effect of inflation, whereas real rates account for it by adjusting gains to reflect general purchasing power equivalents. For example, from 1985 to 1995, the median price of an existing home in the United States appreciated by 50%, while the Consumer Price Index increased by 42%. Thus, homeowners realized a nominal equity growth of 50%, but the net increase in general purchasing power was only 8%.
Overall this leads to equation:
Where: