Most mortgages apply a portion of the payment toward the principal amount owed in order to pay off the loan by the end of the term. This acts like a forced savings for the homeowner because as the loan is reduced, the equity grows which increases their net worth.
The other contributor to equity is appreciation. Most homeowners don’t realize the increase in value until they sell the home or do a cash-out refinance, but the increase is real and part of their equity. If the expected appreciation is averaged over the anticipated time for the home to be owned, the value of the equity increase can be proportioned annually or monthly.
Combining appreciation and principal reduction with leverage, it’s possible to build a case that a home is definitely an investment. Leverage is the ability to control a larger asset with a smaller amount of cash using borrowed funds. It has been described as using other people’s money to increase your yield and it applies to homeowners and investors alike.
The table on the picture above shows that even a modest amount of appreciation combined with the amortization of a loan can cause a substantial rate of return on the down payment and closing costs.
This example assumes a 3% acquisition costs on the home with a 4.5% mortgage rate and the resulting equity at the end of five years. The larger down payments lower the yield because it decreases the amount of borrowed funds.
If a borrower buys a home that appreciates at 2% a year with a 3.5% down payment on an FHA loan for 30 years, the down payment and acquisition cost factored by the equity will produce a 28% return on investment each year during the five year period.
A home can be many things including an investment. You can use this Rent vs. Own calculator to see the effect that appreciation and principal reduction can have on a home purchase in your price range. If you have any questions, I’m a phone call away at (928) 486-6227.