Source: Adapted from zillow.com

When I returned to the San Francisco Bay Area in July 2006, real estate prices were absurd. At the time, I had also saddled myself with a massive amount of school loans. That said, no-doc loans were all the rage, and I probably could have secured a hyper-expensive mortgage. Instead, I elected to pursue a more rational path, and resolved to buy a house after an earthquake.

Then the financial crisis came along, and I decided this event was probably the best opportunity I would ever have of owning a home in Northern California.

In December 2009, I purchased my first home at what was a 29% discount to the home’s all-time high.

I thought I was a genius as I watched my home’s value rise nearly 8% on Zillow.com in just seven months. Because of the leverage provided by my mortgage, my home equity value rose by an astonishing 30%.

Then the housing recovery faltered, and my home’s value declined by nearly 13% from my initial purchase price, where it now stands at a 10-year low. My mortgage debt magnified this decline, and now my initial home equity declined by a whopping 50%.

Fortunately, I still have positive home equity, the estimated rent I could charge for my home is about 13% greater than my current mortgage payment, and the economy appears to be picking up. Furthermore, because of other savings and investments, the hit to my home equity had a less dire impact on my net worth. I also asked the local tax assessor to reappraise my house to reflect the decline in the local housing market, which ultimately saved me a ton of cash.

On the bright side, if the local housing market ever returns to peak levels, my 50% loss would turn into a near tripling of my initial investment. Furthermore, while my market timing wasn’t perfect, I at least avoided 77% of my home’s decline from the peak. While I doubt this market will ever return to those peak levels in the next decade, I also doubt it will remain at 2002 prices forever.

What this personal example shows is how the leverage inherent in the housing market can very easily create or destroy wealth. Since most people have most of their wealth tied up in their homes, even small price fluctuations like mine can have a dramatic impact on one’s home equity and, ultimately, net worth.

When people see their net worth decline substantially, they rein in spending and increase savings. If their home equity turns negative — that is, they own more on their homes than their homes are worth — they have an economic (though not moral) incentive to walk away.

Hopefully, macroeconomic trends improve, and help drive a sustainable increase in housing prices. This housing recovery would give people their confidence back, and they likely would start spending again, creating a virtuous economic cycle.