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Equity and Housing Market

Can we connect some of Monday’s PwC presentation to the housing market?

 

We learned that assets are the economically valuable resources a company or individual owns, while liabilities are the economically valuable resources a company or individual owes. Equityrepresents the net worth and is equal to assets minus liabilities.

 

Now say a friend of yours just bought a one million dollar house (for easy numbers) by providing the twenty percent down payment to the seller of the house. The other eighty percent she still owes to the bank as a loan.

So she got:   $1,000,000

And still owes:   Think about it.

 

Once again:   Assets ― Liabilities  =  Equity

 

What’s her equity?

 

You should arrive at the conclusion that her equity is

$1,000,000 ― (80% of $1,000,000)  , which equals

$1,000,000 ― $800,000 = $200,000

 

Stay with me, now. The price of a house changes over time. People usually want the bad news first, so we’ll start with that:

Your friend’s house dropped to be worth six hundred thousand dollars.

 

Assets got lowered, right? She still has to pay that debt to that bank, though. Equity is…

 

$600,000 ― $800,000 =  - $200,000   <-- negative!

 

What will she do? She tells the bank she can’t pay for the house, so the bank will take it under foreclosure. She walks away, totaling with a loss of $200,000 from that original down payment. The bank, meanwhile, lost money from loaning $800,000; it ended up having a $600,000 house. The bank lost $200,000. It’s a lose-lose situation. The accumulation of situations like this led to the housing market crash of 2008.

 

Now you know! But why was she so eager to buy that house in the first place?

 

How about a Palo Alto twist: your friend’s million dollar house becomes worth twice as much, giving her higher assets along with her original debt.

 

$2,000,000 ― $800,000 = $1,200,000

 

An equity of $1.2 million! The housing market is exciting, isn’t it?

 

(Note I have simplified for learning purposes.)

Chase Robbins