The Equity Scam

The Equity Scam

"Buy real estate now. Build equity!" We've all heard these statements by realtors, investment experts, and banks. You buy real estate now and over time you build equity in the property. But what is equity, really?

The simplest definition of equity is the difference between what someone owes on a piece of property and what it is worth. So, if a piece of property is worth $100,000 and the borrower (technically, the bank is the owner) owes $60,000, then the borrower has $40,000 of equity in that property. The borrower can then apply to a lending institution and get a loan on that equity, often up to the full amount of equity in the property.

So how is equity bad? Because it involves borrowing, and uses the home as a collateral. If the borrower defaults on this new debt for whatever reason, they are at risk of losing their home, even if they are current on their first mortgage. Also, if the borrower has to sell, they now have to sell at least at the price that covers both the first and second mortgage, which can be tough if the housing market is in decline, as so many homeowners have discovered over the last few years.

Some argue that equity is great because when you sell the home you have this lump sum of cash, but if the homeowner has sold their primary residence, they now need to find another place to live. Profits can quickly be eaten up in new mortgage and title fees for the new home, and by realtor fees in selling the old one.
This theory does work for those homeowners who decide to sell a large home and downsize into a smaller, less expensive home, but the average consumer wants to at least maintain their current standard of living. Banks know this.

Consumers who have overburdened themselves with credit card debt can often get a consolidation loan with a much lower interest rate by using home equity. The danger though is if the consumer hasn't learned any lesson, they run the risk of running up credit card debt again and again being overburdened. And banks know this.
The solution to this is for the consumer to develop good credit card habits by only using them when necessary, and by practicing sustainable purchasing habits. Only buying goods or services when they can pay for them in full up front is the best habit to have to stay out of credit card debt.

The one positive about equity is that it is there in case of a financial emergency, and knowing that can help relieve stress for many consumers. Far too often though, it is used unwisely, as in for purchasing cars or other depreciable goods, starting risky businesses, or paying for a child's college tuition (they have loans for that). Any time an equity loan is taken out, the borrower risks losing their home if they default.

If you must use an equity loan, use it wisely. Use it for an emergency. Don't listen to the banks, they want you to be borrowing forever. Focus on paying down your debt, not on adding more.