Today’s homeowners are paying down mortgage faster than ever before as rapid loan amortization builds wealth across America.

Which is better for accumulating equity, lower prices or lower interest rates? Both lower the monthly cost of ownership and result in more disposable income. Obviously, the banks prefer higher prices to recoup their capital from their bad bubble-era loans, so they are offering 4% interest rates to prevent prices from going any lower. I think most buyers would prefer lower prices, but since the banks make the rules which determine market prices, low interest rates and high prices are what we get.

From a homebuyers perspective low rates or low prices depends on how they acquire the property. All-cash buyers would far prefer lower prices because they gain nothing from cheap debt they don’t use. From a financed buyer’s perspective, lower interest rates are better even if they pay higher prices.

If a financed buyer holds a property for 30 years and pays off the debt, how they financed the property doesn’t matter; however, if they sell the property before paying it off entirely, low mortgage rates are superior because they amortize faster. Assuming equal rates of appreciation during the holding period, a financed buyer using a low mortgage rate will accumulate more equity than a buyer who pays a higher mortgage interest rate; that’s the math. The key question is whether or not appreciation rates would be the same.

Buyers who purchase during a period of high mortgage rates may get the boost in appreciation from declining rates, so they may enjoy more appreciation than a financed buyer who buys today when mortgage rates are low. Over the last 30 years, declining mortgage interest rates added significant appreciation above and beyond the growth in income; today’s buyers won’t get the same boost.

Low mortgage rates build equity faster through amortization but slower by appreciation. High mortgage rates build equity faster by appreciation but slower through amortization.

Since we are in an environment of low rates that are likely to rise, going forward, more equity will accumulate by amortization than appreciation — assuming homeowners don’t spend it.

Andrew Haughwout, Donghoon Lee, Joelle Scally, and Wilbert van der Klaauw, February 22, 2016

The largest category of household debt—mortgages—has been essentially flat since 2012, in spite of a substantial rise in housing prices over that period. …

Since new buyers have to borrow more at higher prices, the only way aggregate debt levels can remain flat is if people are paying down debt and not incurring more debt while their neighbors take out large new mortgages.

Fact 1: It isn’t foreclosures. Our first suspect for possibly holding mortgage balances down is foreclosures. … So while charge-offs related to foreclosures are still holding balances down, their influence is fading. Fact 2: Purchases Aren’t Adding as Much to Balances as They Used to. A second contributor to the total balance is home purchases, which are often associated with a borrower originating a new mortgage that adds to the total debt outstanding. Of course, sellers often have mortgages, too, and those will be paid off when the transaction takes place. In a typical situation the buyer’s newly originated loan will have a higher balance than the one the seller is paying off. …This is always positive, but has fallen from nearly $1 trillion in 2006 and 2007 (at an annual rate) to about $350 billion now. So transactions are pushing up balances, but not to nearly the extent that they were during the boom.

Part of the reason this gap is currently so small is because many of the sellers today just emerged from being underwater, and they are selling to get out of a property they can’t afford. So rather than a typical seller leaving with many years of accumulated equity, many of today’s sellers leave with nothing, and they are happy to do so.

(See: Many homeowners downsize when released from their bubble-era debtor’s prison)

Fact 3: Equity Withdrawal Is Very Low.The third major factor to consider is equity withdrawal. … After 2007, though, equity extraction began to decline and is now a far less important source of debt growth, contributing only about $30 billion in 2015. In fact, … the small amount of cash-out refi going on is almost completely offset by people repaying second mortgages and HELOCs.

One of the reasons for such low mortgage equity withdrawal is the survivor effect. Hedge Funds and Mutual Funds generally under-perform the market, but the extent of this under-performance is often masked by the elimination of the poorest performing funds. Similarly, part of the reason there is so little mortgage equity withdrawal today is because those mortgage holders who survived the bust were the ones least likely to have overextended themselves with HELOC borrowing. In other words, the bust purged the Ponzis.

Fact 4: First-Lien Principal Pay-Down has Grown a Lot. The final piece to consider is the reduction in mortgage balances that comes from the everyday hum-drum making of scheduled payments … Why Has Pay-Down Increased So Much? The rate at which a mortgage is paid back is governed by the interest rate on the loan, and how many months are left before the loan is scheduled to be paid off. These factors have been pushing up the percentage of each mortgage payment that reduces the outstanding balance for some time, with the result that mortgage pay-down has now become a major drag on the growth of household debt.

A major drag? I think they mean a major advancement, don’t you think? It’s certainly an improvement over the behavior we witnessed during the housing bubble.

HELOC Abuse

One of the most surprising statistics I discovered when researching the housing bubble was the decline in aggregate home equity during the housing bubble. During a period of time when house prices more than doubled, home equity actually declined. How did that happen?

Mortgage equity withdrawal (aka HELOC abuse)

People actually borrowed and spent their home equity faster than it accumulated during the most rapid rise in home prices in US history.

People who purchase real estate use the phrase “building equity” to describe the overall increase in equity over time. For purposes of illustration, equity can be broken down into several component parts: Initial Equity, Financing Equity, Inflation Equity, and Speculative Equity.

Initial Equity is the amount of money a purchaser puts down to acquire the property.

Financing Equity is the gain or loss of total equity based on the decrease or increase in loan balance over time.

Inflation Equity is the increase in resale value due to the effect of inflation. This kind of appreciation is the “inflation hedge” that provides the primary financial benefit to home ownership.

Speculative Equity is the fluctuation in equity caused by speculative activities in a real estate market. This can cause wild swings in equity both up and down.

If life’s circumstances or careful analysis and timing cause a sale at the peak of a speculative mania, the windfall can be dramatic — of course, it can go the other way as well.

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