When is "equity" really equity?

By Joel Persinger
YourRealEstateDude.com

As I walk through my neighborhood each morning I can do something that I could hardly have done twenty years ago. I can see my neighbor’s equity in their driveways. Over the last five or six years, some of my neighbors seemed to have struck it rich. Suddenly they were able to fulfill the new American dream of having more “stuff” than the guy next door. Almost over night, driveways were populated by high end luxury cars, new trucks, dune buggies, RVs or boats, all purchased with something called “equity.” But, what exactly is equity?

If you listened to all the late night infomercials or “Get Rich in Real Estate” books that came out during the recent real estate boom, you are probably convinced that equity is the money you have buried in your house just waiting to be tapped. It’s as if you had a hidden deposit of crude oil just a few feet under the grass in your front yard and every huckster in the world knew a way for you to tap that thing the easy way and live the good life. The problem is; that’s not how equity works.

In the purest sense of the word, equity is a rough estimate of the amount of money you “might” receive if you sold your home at any given moment. That estimate is a moving target at best, since property values rise and fall as the market shifts. Thus, the equity you had last year is not the same as the equity you have this year, or the equity you will have next year. It’s as if that crude oil deposit under your lawn had the oddball ability to grow or shrink at a moment’s notice without first consulting you. Consequently, taking out loans against your equity can be somewhat risky depending upon what you plan to do with the money.

Some of the folks in my neighborhood took out loans against their equity to improve their homes. In doing so, they increased the value of the property and along with it, their “equity.” One fellow I know purchased his home long ago. He owed very little on it and wanted to improve the property. He took out a loan for $100,000 and improved the landscaping, added a garage, put in a new driveway, RV parking a covered porch, new windows & doors and fixed up the inside. When he was done, his home was a much nicer place to live and the value had increased by about $150,000. Knowing that equity rises and falls like the tide, he then applied himself diligently to paying off the loan as soon as possible.

Another fellow used about the same amount of his equity to buy toys which depreciate rather quickly. If you have ever purchased a new car, RV or boat, you know that the value of such items decreases dramatically the moment you take them home. In his mind, he was living the good life. He had all the toys he ever wanted and then some. But, the market shifted and the interest rate on his $100,000 loan started to climb. Suddenly, living the good life started to become painful. So, he refinanced his house and rolled the $100,000 into the original amount he owed. Now he has one giant loan with one giant payment and I haven’t seen his toys leave his driveway very often of late. He works a lot.

As you consider the two examples I’ve given you, it’s important to remember the classic definition of “equity” which I gave you at the beginning. It is a rough estimate of the amount of money you “might” receive if you sold your home. It is not a bank account, a gold mine or a giant oil deposit under your front lawn. You can take a loan against that estimate, but it is a loan against the “possibility” of future earnings. You only really have equity when your house is sold and you have the money in your hand. Then and only then do you know for certain how much equity you really had.