Real estate has been described as the basis of all wealth. Without considering income or investment property, buying a home to live in is an incredibly powerful way to build wealth or financial net worth.
A home is an asset measured by the size of the equity. Equity is simply the difference between the value of the home and the amount owed. There are two powerful dynamics at work to increase the equity which include appreciation and amortization.
Appreciation occurs when the fair market of the home increases. The shortage of available inventory coupled with high demand has contributed to an 18% increase in value in the past year on average for homeowners in the U.S.
Most mortgage loans are amortized with monthly payments that include the interest that is owed for the previous month and an increasing amount that is paid toward the principal loan amount so that if all the payments are made, the loan would be repaid by the end of the term.
A 30-year mortgage at 3.5% interest on a $400,000 loan amount would have a principal and interest payment of $1,796.18 every month for 30 years. After the interest is applied from the first payment, $629.51 would reduce the loan amount, thereby, increasing the owners’ equity.
Each succeeding payment would have an increasingly larger amount applied to the principal and a decreasingly lower amount applied to interest.
Recently, CoreLogic reported that homeowners with mortgages have seen their equity increase 29.3% since the second quarter of 2020. Equity rich is defined as when combined loans secured by a property are no more than 50% of estimated market value. ATTOM reported that 42% of mortgaged homes in the U.S. are considered equity rich as of the fourth quarter of 2021.
Another advantage of this powerful asset is that borrowing money against the equity of your home is a non-taxable event. Regardless of whether it is a refinance or a home equity loan, the borrowed money is not income and not taxable.
A homeowner could stay in the home for years and as the home increases in value due to appreciation, they could borrow against their equity as many times as the value will justify. They could continue to pull money out of their home for decades and under the current tax law, they could die and will the home to their heirs who would receive a step up in basis and the taxes would never have to be recognized.
Lastly, let’s consider the home as an investment by looking at the rate of return. Obviously, it is a personal asset that the homeowner will be able to live in, enjoy, raise a family, and share with their friends. In calculating the rate of return, we consider a $375,000 home with a 3.00% 30-year FHA mortgage with a 3.5% down payment. Using an annual appreciation of 3% and normal amortization, the $13,125 down payment in this home turns into a $148,062 equity in seven years. The rate of return calculated is over 40% per year for the seven-year holding period.
Even if you discounted the ROI by half for all the unforeseen other expenses that may affect the real equity, it is still a 20% return on investment which could easily justify why purchasing a home should be your first investment.
It is challenging, particularly in some markets with low inventory, multiple offers, rising prices and increasing interest rates, but the advantages of owning a home are significant. Would-be homeowners need the facts about their market and how to get into a home. Start with downloading the Buyers Guide and make an appointment with a trusted real estate professional.