When creating wealth, it is important to understand the basic balance sheet equation--assets equal liabilities plus equity. In real estate, your home is an asset and outstanding mortgage principal is a liability. Equity relates to financial ownership and describes the difference between your property value and the outstanding mortgage principal balance due. As a homeowner, your objective remains to establish significant home equity--for the least amount of risk.
Anything of value, including your home, may be considered an asset. Like any asset, property values are largely influenced by supply and demand. Home prices are high in locations where real estate supply is low and housing demand is high. Because of this supply-versus-demand relationship, home prices generally increase during periods of economic expansion when plentiful jobs support elevated housing demand. In terms of supply, housing prices are generally highest in downtown areas where building space is limited.
A mortgage is a secured loan, which is backed by your home as a collateral asset. This means the bank can seize your home and auction it off to make good on missed loan payments. In exchange for loaning mortgage principal, the bank collects interest payments until maturity. A lender charges interest according to prevailing economic conditions and the strength of your personal finances. Mortgage rates are generally lower amid recession, when loan demand is weak. Mortgage amortization describes the process of paying off your home loan. At maturity, your mortgage principal balance would be zero.
You establish home equity as your property value increases and the mortgage is paid down. Growth in home equity accelerates when you make aggressive mortgage payments and the economy performs well. When property values decline amid recession, you may find yourself in a negative equity situation in which you would owe more on the mortgage than the home is actually worth. Negative equity would further complicate a pre-foreclosure deal, when you would put your home up for sale to avoid foreclosure after mortgage default. The bank must agree to a short sale and accept less money on the home than its outstanding mortgage principal due.
When purchasing real estate assets, you should learn to balance risks versus rewards according to your investment expertise and housing objectives. As a do-it-yourselfer, you may prefer to explore the high-risk and high-reward market for foreclosed homes. A foreclosed property typically sells at a steep discount, because it is in need of extensive repairs. After rehabilitating the property, it may be sold for a large profit. For less risk, you would purchase a maintained home within a safe neighborhood of stable property values. Your profit potential, however, would be limited because of the relatively high price you must pay for this home.