Home equity is created in one of two ways (assuming increasing home value and a non-negatively amortizing first mortgage).
In the first method of creating equity, the homeowner pays down the principal balance on the mortgage. This increases the difference between what is owed on the home and what the home is worth.
In the second method of creating equity, a home’s value increases over time. This increases the difference between what is owed on the home and what the home is worth.
Because both methods create equity, homeowners often confuse the two.
In Method #1, the homeowner takes dollars from a paycheck that have already been taxed and places them "on deposit" with the home. The money can only be recaptured when the homeowner sells the home or remortgages.
In Method #2, the home itself creates value. The extra "dollars-on-paper" can be paid as real dollars when the homeowner sells the home or remortgages.
The differences are subtle, but important. Method #1 depletes the homeowner’s personal funds to "create" equity and that means that no new wealth is created. Method #2 uses no personal funds at all.
When considering your personal mortgage plan, remember that principal paydown and home appreciation are not equals with respect to building equity.
