How To Avoid Equity Leaks

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It can happen quite innocently like not closing out that equity line of credit after it's paid off, tempting you to purchase depreciating assets using your home as collateral. Or less innocently, like making extensive over-improvements to the home that won't return twenty-five cents on the dollar. Whatever the demon, the end result is the same -- shrunken equity, loss of financial options, perhaps even a net loss on your investment.

Shrinking equity may be more common than we think, the Consumer Federation of America says that between 1995 and 1998 the average homeowner saw equity decline.

"As the economy slows, most Americans will try harder to pay down debt and build wealth but will find both more difficult," said Stephen Brobeck, CFA executive director.

We'll begin by defining equity, then examine three areas you can manage to avoid an equity leak in your home.

In simple terms, equity is what a ready, willing and able buyer would pay for your home today (known as market value) offset by outstanding debts you have against it. These could be mortgages, equity lines of credit or other types of liens (debts) against the property.

According to the National Association of Realtors, the mean sale price for an existing home was $114,400 in 1989, a figure which rose to $176,200 in 2000. That's an annual increase of 4 percent nationwide, though obviously higher in some areas, lower in others. This means that a home purchased in January of 2000 for $150,000 could have appreciated to $156,000 in one year. Since equity works on the principle of compounding, the market value could increase an additional $6,240 the following year to $162,240. (In addition, of course, equity would increase because the original mortgage note is being paid down each month.)

But equity buildup is not merely based on average appreciation. Negative factors like a softening economy, a rise in the unemployment rate, and higher mortgage rates can make home purchasing less attractive. In such circumstances, sales can slow and appreciation may suffer.

While there's little one can do about the economy, there's much you can do to better manage your equity. The following three areas comprise the majority of missteps consumers face in managing home equity:

1. Excessive/Improper Refinancing

Just because you refinance to a lower interest rate loan doesn't necessarily mean that you have less debt against the property. In fact, many consumers pull cash out when refinancing, causing the mortgage balance to increase.

While there's nothing wrong with a high loan-to-appraised value mortgage, you don't want mortgage and selling costs to exceed the property's market worth. Otherwise, be prepared to bring a check to closing when you sell the house.

2. Over-leveraging with equity lines of credit and other liens

Innocent, yet equally deadly forms of equity loss come from excessive equity lines of credit and other types of liens/debts against the property. Tapping into your equity is fine to make an appreciable improvement to your home, while accessing equity to pay for depreciating assets like boats, recreational vehicles, etc. may make far less financial sense. Owners also fail to realize that unpaid property taxes eat away at equity, especially with interest and penalties that accrue on a daily basis until paid. The message here is that even though the market value of your home appears rosy, you need to subtract all outstanding debts to determine the true amount of equity in your property.

3. Over-improving the home

While most improvements should be an equity builder, over-improving the home for the neighborhood is an increasingly typical way consumers waste money that won't be returned come sales time. Do your homework when it comes to the type of improvement, the materials used as well as how much the improvement could return in a sale to determine if you'll gain equity or lose money. While applied primarily to remodeling, evaluating individual improvements prior to building a new home is equally important for building and maximizing equity.

For most Americans, equity in a home is one of the greatest contributions to net worth. Managing your equity with the same, if not greater fervor as your retirement account goes a long way in reaching positive, financially-productive results and hearty, healthy equity.