Real Estate 101

Let's start with a brief accounting lesson.

Assets = Liabilities + Equity

How does this apply to real estate?

A house is an asset. (Something of value that you own.)
A mortgage is a liability. (Something you owe to someone.)
The difference between the value of your home and the amount you owe the lender is the equity you have in the home.

Re-arranging the equation above, we get:

Equity = Assets - Liabilities

Or, in our case:

Home equity = Value of the Home - Mortgage Balance

Let's use real numbers. If I buy a home worth $300,000 and I take out a $270,000 loan to pay for it, I will immediately have $30,000 in home equity.

By the way, the same equation can be applied to a person's net worth.

Net Worth = Assets - Liabilities

Continuing with the above example, if I own no other assets and have no other liabilities, my net worth will be $30,000 after purchasing the house.

Mortgages

A home loan is called a mortgage. There are many types of mortgages with different terms and rates. The most common mortgage in the United States is a fixed-rate 30-year conventional mortgage. The interest is fixed at the beginning of the loan term and never changes. A mortgage payment has 3-4 components that make up the amount of the payment.

Principal and Interest. This is the portion that goes toward paying down the loan and interest owed to the lender. (Sometimes called debt service.)
Taxes. The lender collects and escrows money from you to pay your property taxes on your behalf each year.
Insurance. The lender collects and escrows money from you to pay your homeowner's insurance on your behalf each year.
Private Mortgage Insurance (PMI or MI). This is sometimes required by the lender, for their protection, if you make a small down payment (< 20%).

Note: On conventional loans, once you have reached > 20% equity, you can request to cancel PMI.

It's not uncommon to see lenders and people in the real estate industry refer to these payments as PITI (principal, interest, taxes, and insurance).

Here's an example from a mortgage statement that shows how the amount due ($936.00) is broken down to the individual components (Escrow is for both the taxes and insurance).

Mortgage Statement Payment Explanation

Closing Costs

When you purchase a house, you make an offer that is accepted by the seller and then you are said to be "under contract". Both parties have signed an agreement for the sell and purchase of the house. After various activities and 4-6 weeks have passed, you will close on the house. This represents the end of the process and you become the new owner (the deed to the property is now in your name).

There are a lot of costs associated with closing. These includes such things as attorney fees, loan origination fee, discount fee, processing fee, underwriting fee, wire transfer, credit report, tax service, flood certification, title insurance, appraisal, etc. On average, closing costs range from 2-5% of the loan amount.

Is Buying a House a Good Investment?

Owning a house for an extended period of time nearly always put you in a stronger financial position relative to not owning a house. The caveat is "nearly always." Losing money is possible, but not probable.

The image below shows an example of a recent multi-year period when home prices were declining. Homeowners in 2007-2008 saw their home values drop significantly. Had they been forced to sell due to a change in their life circumstances, they may have lost a lot of money on their homes.

For this reason, I don't recommend buying a house unless you intend to own it for a long time. How long is long enough to avoid a potential loss? Let's look at the data.

In the period from 1890 - 2016, there were 28 years with losses. Rather than looking at one year periods, if we look at 5-year periods during that time, there was a positive return (gain) in 82% of the periods. Further, most of the "losing periods" were pre-1916, during The Great Depression, or during The Great Recession.

If you're going to buy a house, and want to minimize the probability of losing money, plan to own it at least 5 years. And the longer you own it, the greater the likelihood that you will build wealth.

How Much do Houses Appreciate in Value?

Historically, homes have appreciated at a rate higher than the general inflation rate. In fact, since 1983 home prices have grown at nearly double the rate of other items measured in the Consumer Price Index (CPI)! Over that period, the average annual appreciate rate is ~4.0 %. This may not seem like much, but when you take into account the inherent leverage with home ownership, this can result in significant wealth creation!

CPI and House Prices

Leverage

When you buy a house and finance it with a loan, this is called leverage. Leverage amplifies the rate of return on your down payment, based on the underlying asset prices movements.

Let's discuss an example to illustrate how leverage works. I'm going to ignore transaction costs for the sake of simplicity. Pretend that you buy a house for $100,000, put $20,000 down, and get a mortgage for $80,000. This is what the rate of return would be on your money if the house price goes down $4,000 in value versus up $4,000 in value:

Leverage

As you can see in the table, a $4,000 change in the value of the home may only be a 4% change, but it results in a 20% change in your equity. That's the power of leverage!

Renting vs. Buying

Everyone has to make a decision regarding shelter. Do you want to rent a place to live or buy a place? This can be a difficult decision. The spreadsheet below was designed to make the financial comparison more clear.

Rent vs. Buy Comparison