Home Equity – Definition

Cite this article as:"Home Equity – Definition," in The Business Professor, updated December 3, 2018, last accessed October 27, 2020, https://thebusinessprofessor.com/lesson/home-equity-defined/.

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Home Equity Definition

In simple terms, home equity is the proprietor’s equity in their home, which is nothing but the total value of the property minus liens. A homeowner can acquire home equity in two ways:

1. By paying a down payment that guarantees an outright ownership claim to a percentage of the property, or

2. By paying mortgage instalments for a fixed period, thereby assuring a gradual increase of ‘ownership’.

Besides any appreciation in market value of the property will also add to the home equity value.

A Little More on What is Home Equity

Suppose a homeowner purchases a home via a mortgage with an arrangement that he will be paying the loan back on an Equated Monthly Installment (EMI) basis. A year later with 12 installments paid, the homeowner has cleared a percentage of the loan, which also implies that he/she is now in clear ownership of a corresponding percentage of the property. That part of the property that is now in clear possession of the homeowner is his/her home equity.

Home Equity Example

Let us say Mr Smith bought a property worth $200,000 with an outright down payment of $40,000 (20%) with a mortgage for the remaining 80% value of the property payable at $1000 per month. His immediate home equity after the down payment will be $40,000. A year later with 12 instalments having been paid, Mr Smith’s home equity will increase to $52,000. Now, let us assume that that the market value of the house increased by $10,000 during that year. In this case, Mr Smith’s home equity after a year of purchase will stand at $62,000.

Ways to Leverage Home Equity

Holding home equity as an asset is intrinsically different from holding other forms of assets. For one, home equity is not a liquid asset and as such, it cannot be monetized as instantly or conveniently as other assets. Also, the monetary value of a home equity is based on market speculations and hence, in the event of a sale of the equity, there can be a huge discrepancy between the speculative market value of the home equity and the price it actually manages to fetch.

That is not to say that home equity cannot be leveraged at all. Attaining a home equity loan or a home equity line of credit (HELOC) with the home equity as a collateral is an effective means of bringing liquidity to what is otherwise a fixed asset. In fact, a home equity can be utilized as an essential instrument for financing big ventures, mortgaging other properties and even taking out personal loans.

Reference for Home Equity

Academic Research on Home Equity Line of Credit (HELOC)

Method and apparatus for predicting outcomes of a home equity line of credit, Beardsell, M., Burgess, H., & Calem, P. (2011). U.S. Patent No. 7,958,048. Washington, DC: U.S. Patent and Trademark Office. This patent discloses tools for forecasting cash flow and income from a collateral based loan portfolio that are particularly useful in volatile markets. In this paper, consumer payment behaviour is modelled and account movement is simulated. The model can be used to compare actual payment and frequency of payments to delinquency.

Home Equity Line of Credit Securitization: Issuer Issues, Carnahan, S. W. (2005). The Journal of Structured Finance11(3), 30-32.

Adverse Selection in the Home Equity Line of Credit Market, LaCour-Little, M., & Zhang, Y. (2018). Journal of Real Estate Research40(3), 453-474. This paper examines the constant scrutinization of securitization for contributing to mortgage breakdown and ensuing financial crisis. This paper employs the OCC Home Equity database to develop estimates of default and prepayment probabilities for home equity lines of credit originated during 2004-2008 and tracked through 2014. The paper aims to show how securitized home equity loans come with higher risks and prepayment costs than normal loans.

Home Equity Line of Credit versus Home Equity Conversion Mortgage Line of Credit., Salter, J. (2014). Journal of Financial Service Professionals68(6). This paper explores the choice that retirees need to make between a home equity line of credit and a reverse mortgage line of credit to protect against longevity and liquidity risks in retirement. The paper compares and contrasts these two options with regard to several factors including whether the line of credit grows, whether there is a requirement for payback, and what costs are involved.

Sources and uses of equity extracted from homes, Greenspan, A., & Kennedy, J. (2008). Oxford Review of Economic Policy24(1), 120-144. This paper presents estimates of the disposition of the free cash generated by home equity extraction to finance consumer spending, outlays for home improvements, debt repayment, acquisition of assets, and other uses. It estimates free cash as cash available net of closing costs and repayment of other mortgage debt.

The financial crisis at the kitchen table: trends in household debt and credit, Brown, M., Haughwout, A., Lee, D., & Van Der Klaauw, W. (2013). This paper explores the rate of decrease of of household outstanding debts since the onset of the financial crisis. The paper analyses the factors that led to this decrease aside from the historical increase lenders charge-offs. Using an analysis from the New York Fed’s Consumer Credit Panel, the paper reveals that  households actively reduced their obligations during this period by paying down their current debts and reducing new borrowing. The paper also states the impacts of this reduction.

Securitization and risk: empirical evidence on US banks, Uzun, H., & Webb, E. (2007). The Journal of Risk Finance8(1), 11-23. This paper aims to offer a comprehensive comparison of the characteristics between banks that securitize and banks that do not and to provide evidence of the capital arbitrage theory of securitization.

Financial literacy and mortgage equity withdrawals, Duca, J. V., & Kumar, A. (2014). Journal of Urban Economics80, 62-75. This paper examines the relationship between mortgage equity withdrawals (MEWs) and credit-constraints. The paper assesses linkages between MEW and financial literacy/education using the Health and Retirement Study (HRS) and Panel Study of Income Dynamics (PSID). The paper finds that the financially literate are 3–5 percentage points less likely to withdraw housing equity via non-home equity loan mortgages using the HRS, while college graduates are 5 percentage points less likely than those without a high school degree in the PSID.

Benefits of relationship banking: Evidence from consumer credit markets, Agarwal, S., Chomsisengphet, S., Liu, C., Song, C., & Souleles, N. S. (2018). Journal of Monetary Economics. Using a unique panel dataset that contains comprehensive information about the relationships between a large bank and its credit card customers, this paper shows that relationship accounts exhibit lower probabilities of default and attrition, and have higher utilization rates, than non-relationship accounts. The paper aims to show how information that the lender has at its disposal can be used to mitigate credit risk on the credit card account.

Causes of the financial crisis, Acharya, V. V., & Richardson, M. (2009). Critical Review21(2-3), 195-210.

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