A family home is not an investment or a consumable good. It represents a deliberate allocation of family wealth to shelter. This allocation of wealth is a commitment to spend accumulated cash savings on a down payment to acquire ownership, and save future income for mortgage payments required to retain that ownership.
The opportunity cost of allocating cash savings and future income to build home equity is the lost interest that would have been earned had it remained or been placed in savings. Interest on the mortgage, not the principal, is offset by the implicit rent the homeowner does not actually pay but must charge himself for use of the property as the family shelter.
The amount of equity in a family home is the financial cushion that absorbs the effects of a local economic downturn or a family financial emergency. As with any family nest, the homeowner’s instinct for self preservation rationally compels him to establish the ultimate equity – a home free and clear of debt, the historical exorcism exemplified by mortgage burning celebrations. Clear of debt, the family attains an equity that provides the maximum level of ability to retain the home against all odds. A family solvent at last, a homestead equity beyond the reach of the sheriff.
Equity loans, also known as second mortgages, were forbidden in California until the 1970s. This prohibition was a shield against the insidious lending practices experienced in the ’30s depression. The homeowner needing cash and wanting to borrow against the wealth stored in the equity of his home would enter into an agreement with the bank not to sell or further encumber the family home since the lender was barred from taking a second trust deed lien on the property. Unlocking the equity in millions of California homes to provide collateral for loans was the work of mortgage bankers.
Thus, the home equity loan was created by deregulation. The purpose of that deregulation was not to preserve home ownership, or increase the percentage of homeowners in the population, or even to better prepare the population to provide for themselves in old age. It was created by the desire to spend beyond the “constraints” of personal incomes. In 1986 came the tax advantage of writing off the interest on equity loans which funded such purchases as cars, pickup trucks, vans, stock market speculation, and, as a long-term benefit, education. All went well until personal income began to decline nationally after 2000.
Eventually the deregulation allowing seconds led to no-down acquisitions with piggyback second loans, and equity lines of credit secured by the principal residence to provide the homeowner with funds to purchase consumer goods and speculate. In turn, further encumbering the family home reduced family solvency and the ability to retain ownership of the home during a recession. The reality is that the risk of losing the family home is directly proportional to the loan-to-value ratio (LTV) for the loans encumbering the residence. For a reality check, fast-forward from a 50% LTV on property owned in 2005 at the peak of the real estate values into 2010 when the property will be valued at one half of what it was in 2005. Thus, the double-edged sword of even modest 50% leveraging in 2005 leaves mid-range and high-end properties with no equity by 2010 in most areas of California.
Looking forward again, approximately 1 to 1.2 million homeowners in California will lose their homes during the current seven- to nine-year real estate recession following mid-2005 for lack of an equity to sell or retain. Today, bedroom community properties are not listed by true owners, but short-sale sellers and lenders who own REOs. These properties had an insufficient equity cushion in their home at the outset of the recession. Those who had an ARM loan on their property saw their ability to retain the property, whether or not it had equity, simply disappear when the interest and payments reset, or when they lost their jobs. This trend will continue until well into 2011, or 2012, if the recently passed Troubled Assets Relief Program (TARP) attempts, as anticipated, to further prop up unqualified homeowners who will eventually be foreclosed upon due to their insolvency.