One Reason Homeowner Loans May Increase with Property Value
It is relatively well-known within the financial services sector that the volume of homeowner loans made to UK property owners tends to increase with property values. As homes are worth more, property owners are more likely to take out loans based on their equity. The question to be answered is, why?
There are as many theories behind this phenomenon as there are people who espouse them. That didn't sit well with an American professor who was looking for more concrete explanation. So he concocted an interesting experiment meant to determine, once and for all, why people tend to borrow more as the values of their homes rise.
Kellogg School of Management professor of finance Anthony DeFusco looked at the two most common theories explaining the equity phenomenon. Those theories are as follows:
- The Wealth Effect â?? The wealth effect theorises that a person feels richer as the value of his or her home rises. Those feelings of increased wealth could motivate some homeowners to use the equity in their homes to do things like taking holidays, purchasing new vehicles, and so on.
- The Collateral Channel â?? The collateral channel theory suggests that consumers tend to think of equity as a line of credit that increases with property value. They can use that line of credit to finance things too costly to put on credit cards or store credit accounts.
Professor DeFusco assumed that both these theories were part of the explanation he was looking for. His experiment was aimed at determining if either theory was more prevalent than the other.
Price Controls Provided the Answer
DeFusco's experiment needed to eliminate some of the inequities between the ownership and rental markets in order to account for the fact that the wealth effect influences owners and renters differently. He also wanted to account for the economic conditions in different regions that affected housing prices. So he used a very specific data set from one county in the state of Maryland where builders are required to sell a certain volume of homes with price controls attached.
A local law in that area uses the price controls to ensure that moderate and low-income earners can still afford to buy homes. There is a caveat here: buyers of price-controlled homes cannot use the full value of their homes for equity borrowing. In other words, they cannot take out homeowner loans equal to the full value of their equity for a certain amount of time, usually between five and 30 years.
DeFusco looked at the data on both sides of this restriction. He looked at how homeowners used their equity during and after the restricted period. What he learned was fascinating. It is important to remember, as DeFusco explained, that the wealth effect was irrelevant in this data because owners owned the same properties the day before the restriction was lifted and the day after. So among those whose borrowing habits changed, something other than new feelings of wealth was in play.
It Was the Collateral Channel
The result of DeFusco's analysis showed that it is the collateral channel that primarily explains why people tend to seek out homeowner loans commensurate with their equity. People are conditioned to use equity as a revolving line of credit to finance all sorts of higher-end purchases.
DeFusco's explanation doesn't establish right or wrong or make any kind of moral judgement. It does prove something many of us already knew to be true: home equity is a great financing tool that more property owners are taking advantage of through homeowner loans.
Kellogg Insight â?? https://insight.kellogg.northwestern.edu/article/why-are-we-so-quick-to-borrow-when-the-value-of-our-home-rises
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