Erosion of Owner’s Equity

From the New York Times:

A False Sense of Security? You Must Own a Home

THE wonderful world of leverage has lifted homeownership to near-record levels, and we thump our chests with pride at the prosperity and middle-class life that possessing a home implies. Hovering in the background, however, is a glaring statistic: Never before have homeowners actually had such a small ownership stake in the houses they occupy.

The reason is debt. Home prices have gone up a lot, but borrowing against homes has gone up even more in almost all of the last 20 years. “Owners’ equity,” as the Federal Reserve calls the difference, is gradually eroding — a detail that millions of families ignore, focusing instead, perversely, on the rising dollar value of their homes.

“People believe their homes will continue to appreciate in value,” said Mark Zandi, chief economist of Moody’s Economy.com, “so that even if they take out money and reduce their equity, it will all come back very quickly.”

When they sell, most still pocket a tidy sum after paying off their loans. But millions of middle-income families don’t sell; they take out another loan, which they often spend, surveys show. And then, as the margin of potential profit — a k a owners’ equity — shrinks, it becomes a little harder for a family to weather an unexpected hardship: an illness, a layoff, a wage cut or a forced early retirement.

There is less market value to borrow against in the event of such setbacks and less cash from a forced sale, particularly if the sale comes as home prices are falling, squeezing owners’ equity from the other end.

Just such a squeeze appears to be under way as home prices level off and begin to drop. The stake that families have in their homes fell faster in the 12 months through March than at any time since the early 1990s, the Fed reports. At the end of the first quarter, the nation’s homeowners owned, free of debt, only 52.7 percent of their dwellings, down from 54.1 percent a year earlier and 57.5 percent at the start of the century. The decline occurred even though owners’ equity, measured in dollars, rose by an astonishing $4.3 trillion since 2000. Unfortunately, mortgage debt rose by $5 trillion.

“Basically people are gradually consuming their capital,” said Edward N. Wolff, an economist at New York University who studies household wealth. “It makes the middle class in particular more vulnerable. Their homes are still their biggest saving, and that is the bottom line.”

Even now, the illusion of rising equity obscures its erosion. For a family with a $50,000 mortgage and a house valued at $100,000, for example, the owner’s equity is 50 percent. Two years pass. The family borrows an additional $60,000, raising debt secured by the house to $110,000. The expected selling price, however, has risen to $200,000. True, the ratio of equity to value has fallen to 45 percent, but in a sale, the family would pocket $90,000, after paying off debt. That is nearly double the cash it would have collected two years earlier.

Home prices, however, must continue to climb for this merry process to continue. Indeed, millions of homeowners seem confident that they will do exactly that over the long run, despite the drop in recent months. After all, home prices have risen in most of the country for most of the last 30 years, the exceptions being the late 1980s through the early 1990s — and, perhaps, now.