Home Equity Values Take the Plunge

Home equity is eroding, and it's not just due to plunging real estate values. Homeowners have treated their properties like bank accounts instead of investments, resulting in less equity and loads of potential problems.

It was only a few short years ago that money seemed to grow on trees. For homeowners, those money trees were planted in their front yard, and the green leafy currency that grew on their branches was courtesy of sky-rocketing home values.

When the sun stopped shining on the real estate market, these money trees began dying of thirst. Cash no longer sprouted from branches; fruits dried on the vine. The source of the drought was not just over-inflated home values; homeowners were also sucking the trees dry. The consequences may be felt for a long time to come.

Spending like it's going out of style

During the last two decades, homeowners have misused their home equity. Many have been less than judicious about taking out home equity loans, including the amounts that they borrowed. Traditionally, a sound reason for such a mortgage is to use the money to make home improvements. Tapping equity for vacations, or to pay off credit card debts, had never been done like this before.

The reason why financial pundits discourage tapping home equity for consolidation or vacations is that the loan does nothing to improve the value of the property. Paying off credit card bills with a home equity loan, which generally comes at a lower interest rate and is tax-deductible, saves money in the short term--but it erodes equity. A better alternative is to live within your means, which may involve sacrificing short-term purchases, such as a vacation, in order to pay off debt.

Borrowing faster than homes appreciate

While the real estate market was flourishing, no one thought twice about tapping equity. There didn't seem to be any problem with borrowing $5,000 if your home was going to appreciate by $10,000.

The problem-as homeowners from coast to coast are finding out-is that the years of double-digit appreciation are being erased by the real estate slump. The reliance on the market to repay tapped home equity through appreciation has proven to be economically unsound. Over the long haul, you can make a profit on your home-but your reward won't be as great if you tap equity faster than the property appreciates.

Like money, your home's equity also doesn't grow on trees. Regardless of market conditions, you should tap equity in your home only if the reason for the loan will result in some increased value, such as home improvement. Homeowners have destroyed their money trees over the last 10 years. Now it's time to return to smart financial habits to start the growth cycle once again.