Home Equity

Home equity is essentially an individual’s financial ownership of a home or other property. The amount of equity one has in one’s home may be calculated by subtracting the amount of money owed on the home’s mortgage, if any, from the total appraised value of the property. In the United States, home equity may be used as a means of obtaining a loan, known as a home equity loan, or a credit line, known as a home equity line of credit (HELOC). Each loan product has its own benefits and drawbacks, which typically differ in interest rates, repayment periods, and maximum funds available. Both, however, typically use the borrower’s property as collateral for securing the loan. Home equity loans and HELOCs are widely offered by banks, credit unions, and mortgage lenders and are commonly used to pay for home renovation costs, college tuition, and other large expenses.

Background

When buying a home, an individual in the United States will typically make a down payment, often but not always totaling about 20 percent of the sale price, and take out a mortgage loan to cover the rest of the cost. The lender will usually require that a real estate appraiser visit the property prior to the sale and determine its fair market value to ensure that its value is equal to or greater than the mortgage, as lenders typically do not loan more than a property is worth. Immediately after the sale, the buyer’s equity in the home will be limited to the sum of his or her down payment and any positive difference between the property’s appraised value and the mortgage amount. As the new homeowner makes mortgage payments, his or her equity in the home will increase, so long as the home’s fair market value increases or remains the same.

For example, consider the following situation: a homebuyer purchases a condominium unit for the sale price of $145,000. Because the buyer is utilizing a first-time homebuyer program, a down payment of 10 percent of the sale price is required to take out a mortgage for the remaining $130,500. Over the next year, the buyer makes monthly mortgage payments that lower the loan’s principal to $128,000. If the unit’s appraised value is $180,000, the homeowner has $52,000 of equity in the property. Assuming the appraised value remains the same, the homeowner’s equity in the property will steadily increase as he or she continues to make mortgage payments. The homeowner’s equity will also increase if the home’s market value increases.

On the other hand, if home’s market value decreases significantly, as occurred frequently in the United States during the global financial crisis that began in 2007, a homeowner may find that he or she now owes more on the property than it is currently worth. Properties in this situation are colloquially referred to as being underwater. The difference between the amount owed and the value of the property is known as negative equity.

Home equity is important for a variety of reasons. First, it ensures that if the homeowner sells the property for its fair market value, he or she will likely profit from the sale even after paying off the remainder of the mortgage. Second, a homeowner may choose to leverage his or her equity in order to pay for home-related or other expenses. This is typically accomplished through the use of a home equity loan or home equity line of credit (HELOC).

Overview

When considering whether to leverage home equity to obtain a loan or a HELOC, one must first determine how much equity is available. Homeowners cannot take out a home equity loan or HELOC if they have negative equity, so only those whose homes are worth more than what they owe are eligible. In addition, a homeowner must research prospective lenders to determine whether he or she has enough equity to qualify. Many lenders require a minimum loan amount and allow homeowners to borrow an amount equal to only a percentage of their equity. As such, some homeowners may not have enough equity to meet the minimum loan requirement and must therefore wait to take out a loan or open a HELOC until they have built up more equity, either through making more mortgage payments or through changes in the housing market.

Although home equity loans and HELOCs can be used to pay for nearly any expense, home repair or remodeling, which can increase the home’s market value and thus its equity, are two of the most common uses for the loan. Home equity loans and lines of credit are also commonly used to pay for college tuition or similar large but infrequent expenses, or consolidate high-interest debt. In some cases, a homeowner might even use the equity to fund a down payment on a new primary residence, vacation home, or rental property. This strategy is risky in that it requires the homeowner to be able to afford multiple payments, and some lenders may not permit funds obtained through home equity loans or HELOCs to be used in such a way.

A home equity loan is similar to any other type of loan in that an individual borrows money from a lender and is then required to pay it back in installments, with interest. Unlike other loans, however, a home equity loan specifically uses a home’s equity as collateral. If the borrower becomes unable to make the loan payments, the lender may require him or her to sell the property and repay the loan with the proceeds.

To obtain a home equity loan, one should research multiple prospective lenders, which may include banks, credit unions, and specialized mortgage lenders. Different lenders will offer different interest rates, fees, and payment terms, so it is important to compare their offerings when searching for the best deal. Next, the homeowner applies for a loan, providing the prospective lender with information such as the home’s value, the amount owed on the home, and any other debts. Homeowners with poor credit or significant debt may be unable to qualify for a home equity loan.

Each lender has its own rules regarding loan eligibility. Many lenders have set minimum and maximum loan amounts, so borrowers requiring more or less money may have to research other lending solutions. In addition, although a homeowner may have a significant amount of equity in his or her home, the lender may not permit all of that equity to be accessed. Typically, a lender will allow a homeowner to borrow an amount of money that, when added to the total amount the homeowner owes, does not exceed a certain percentage of the home’s value. If, for example, a home is worth $180,000 and the homeowner owes $128,000, the homeowner’s total equity is $52,000; however, if the lender limits the homeowner’s combined mortgage and home equity loan to 80 percent of the home’s total value, the homeowner will be eligible for a loan of only $16,000.

Much like a home equity loan, a HELOC allows a homeowner to access a portion of their equity, with the home itself serving as collateral. HELOCs are subject to many of the same restrictions as home equity loans, including minimum and maximum offered amounts and maximum amounts of equity that can be accessed, and they tend to be offered by many of the same banking and loan institutions. However, they differ significantly from loans in practice. A HELOC is a line of credit much like a credit card, and as such, a homeowner may borrow from it until meeting the credit limit. In a home equity loan, the homeowner receives all of the funds at once and cannot borrow more; in a HELOC, however, the homeowner may make optional payments and thus make space on the credit line for future purchases.

The repayment process for HELOCs likewise differs significantly from that of home equity loans, which typically require regular monthly payments. In most cases, a HELOC will be active for a set period of time, which is divided into the draw period and the payment period. During the draw period, the time in which the homeowner may borrow from the credit line, only payments on the interest accrued are required. Some homeowners may choose to make additional payments to reduce their debt or make more credit available. During the payment period, the homeowner’s regular payments will increase significantly because portions of the interest and the accumulated principal will be included.

Bibliography

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