The housing market has exploded in the last five years, and homeowners are finding that the equity in their homes is greater than it has ever been. The equity in a home is the difference between the market value of the home and the amount still owed on it. As home prices increase, so does the equity for those who own their homes. In parts of California, home values have tripled during the last five years, and homeowners are doing increasingly risky things with their newfound “wealth.” Anyone considering borrowing against their home’s equity should carefully consider the possible pitfalls of doing so.

Traditionally, most home equity lending was done for purposes of home additions or remodels. These have been considered low-risk loans, as the house is collateral for a loan that improves the house itself. As a bonus, the improvement usually increases the value of the home, making the loan even safer for the lending company. Occasionally, homeowners default on such loans, but the foreclosed property can easily be sold to recoup the loss. Times have changed, and many, if not most, home equity borrowers are now using the money for different, and riskier purposes.

Thousands of people who have suddenly found themselves with hundreds of thousands of dollars of equity in their homes are treating that value as a windfall of cash. Instead of traditional uses, such as home improvements, borrowers are using their equity to buy more real estate to use as rental property. There are cases of individuals with homes valued at several hundred thousand dollars who have borrowed against their equity, bought more property, borrowed against that equity, and repeated this process six, seven, ten or more times, attempting to build up an empire of rental property. It’s hard enough for most people to manage one mortgage, but some people who are caught up in the “equity frenzy” are now managing ten or more of them! On the surface, it may appear that these intrepid individuals are simply taking advantage of an opportunity, turning several hundred thousand dollars worth of equity into millions of dollars worth of rental property. On the other hand, these “investors” may be inviting disaster.

As more and more people buy real estate on speculation, the equilibrium of the real estate market is affected. The additional competition among buyers, fueled by the real estate speculators, is causing prices to go up even more. Eventually, the market is going to peak. Buyers who need a home to actually live there can only pay so much for them before the homes simply become unaffordable. And not every speculator can own ten rental properties, as the market can only support so many rental properties before the market becomes saturated. Once that happens, prices will fall. And when they do, all of these buyers who purchased their homes using their own home’s equity will find themselves under a mountain of debt.

It’s nice to have some equity in your home. It’s also nice to be able to borrow against that equity for home improvements or debt consolidation. Using your equity as though it was cash you can freely spend is dangerous, as many speculators will soon learn.

Purchase real estate, make improvements to it and then sell for a tidy profit. That is how we are all told we can make a bundle in real estate, but it can lead to problems.

Avoiding the Over Improved Home

There are two basic rules in real estate. The first is you should buy in the right location. The second is do not buy the best house on the block. Instead, you should be a home that needs some work. If you then do the work, you will reap the benefits through increased equity when you sell the home. This is all true, but there is one caveat to the home improvement strategy. People often improve their home so much, they price themselves out of their market.

Assume you buy a property in a neighborhood where comparable homes sell for $350,000. You buy a beater home for $300,000. The goal in buying is to fix it up and gain the $50,000 when you ultimately sell it. This is a smart theory and sound financial strategy when you buy the home.

Let’s assume you live in the home for six years. Immediately after buying, you improve those horrible bathrooms at a cost of $15,000. A year down the line, you simply have to have a bigger, better kitchen and spend $20,000 redoing it. In the fourth year, you find out you are going to have an addition to the family and spend another $20,000 adding a room to the home and upgrading facilities. In year five, your salary goes up and you decide marble flooring would look good in the entrance at the cost of another $15,000. You have now spent $70,000 on improvements for a market that will only support $50,000 in improvements. How are you going to get the money back when you sell?

When buying a fixer upper, it is important to put a plan together and stick to it. More importantly, it is vital that you create a budget and stick to it. This may all sound obvious, but this scenario plays out over and over in the residential real estate market.