This guide gives an overview of everything you need to know about equity in a home: what it is, how to use it, its pros and cons, and more!
Have you ever wondered about the value of the home you live in? Ever thought that your home might be more than just a place for you to live?
If not, then Home Equity is your answer!
But what is it? How does it work? So many questions pop up when we hear the phrase, “Equity in a Home”. So, to answer all your queries and assumptions, stay with us because this guide contains everything you need to know before indulging home equity!
So, let’s begin!
What is Equity in a Home?
Home equity is the value of a homeowner’s interest in their real property. In simple words, it is the difference between the fair market value of a property (the price at which a property can be bought and sold) and the outstanding mortgage balance (what you owe on your mortgage).
Therefore, since home equity is the stake you have in your property, it is considered a portion of your net worth.
How does Home Equity Work?
When you purchase a home through a mortgage loan, the lending party has an interest in the home until you pay off the loan. Therefore, at any point in time, the portion of the current value of your home possessed by you is your equity!
The value of equity in a home tends to fluctuate over time. There are two things that impact home equity:
1. Payment against the mortgage balance
Your equity in a home will eventually increase as you keep on making mortgage payments, that is, repay the loan. Thus, as your outstanding balance will be decreasing, your equity will as a result increase.
2. Property’s value
The value of your property is directly proportional to your equity in a home. So, if the property’s value appreciates, your equity will also increase along with it.
How to Calculate Equity in a Home?
The calculation is a simple subtraction. You take the fair market value of your home, and subtract that mortgage amount that you owe. For example, if the market value of your home is $100,000 and you currently owe $20,000 on a mortgage, then your home equity will be:
$100,000 – $20,000 = $80,000
$80,000 is your current equity in your home.
Is Home Equity an Asset?
Your equity in a home is considered an asset since it represents a part of your net worth. However, remember that it is NOT a liquid asset.
Methods for Increasing Equity in a Home
As discussed above, the two ways to fluctuate equity in a home is through altering the outstanding payments against a mortgage and the value of your property. Here is how you can make changes in each of the two categories in order to acquire greater home equity:
Reducing outstanding mortgage balance
1. Increase your down payment
Down payment refers to the initial sum of up-front money that is paid when purchasing anything expensive like a home. So, one of the quickest ways to reduce the mortgage balance that you owe is to increase your down payment because this way you will directly increase your equity.
For example, if the fair market value of your house is $200,000 and you make a down payment of $10,000 so then you owe $190,000 on your mortgage and your home equity is $10,000.
However, if instead you make a down payment of $40,000, then you owe $160,000, leaving your home equity to be $40,000. Thus, the greater the down payment, the higher home equity.
Moreover, in addition to increasing equity, if you make a down payment of at least 20% (like in scenario 2 where your down payment is $40,000), then you can get rid of private mortgage insurance (PMI). PMI is a type of mortgage insurance that aims to protect the lender when you have a conventional loan in the circumstances that you stop making your payment. Thus, by making a down payment of at least 20%, you will not be losing extra money every month through PMI cost.
2. Make additional mortgage payments
Instead of paying a specific portion every month, try to pay extra. Since only a designated amount is owed every month, if you pay more than this minimum amount, then eventually you are working on increasing your equity in a home!
Even an extra $20 will help slowly build your home equity over time.
3. Shorten your mortgage loan time period
If you pay more of your mortgage every month, eventually the loan time period will shorten. As a result, you will not only benefit from lower interest rates, but also get closer to increasing your equity in a home. Therefore, this way your 10 year loan time period can be shortened to 5 years easily.
4. Try and secure additional income
All of the methods above have one thing in common: paying more on your mortgage. But how will you do so? In addition to saving from your monthly salary, try to find other ways. This includes, seeking inherited money, using gift money, and most importantly, reconstructing your budget.
We often feel that we are saving as much as we can, but if we dig deeper, we will probably come across many unnecessary expenses that we can easily cut off (if not for long, then a short time until the mortgage is paid).
Increasing value of the property
1. Make improvements in your home
Remodelling your house, such as upgrading different areas like the kitchen, garden or the bedroom will certainly increase its worth. You can invest anything in your property, and it won’t be a waste. Whether it’s you investing your time by trying out unique DIYs (Do-It-Yourself) or hiring a professional to make proper renovations. Anything that will make your home better than before will increase its value.
2. Protect the current condition
There’s no harm if you don’t want to invest your time or money in your house. However, do make sure that during that, you don’t harm the current condition. For example, make sure you don’t break anything around like the windows or sink. Because, if you do so, then the value of your house will deteriorate instead of increasing.
Thus, if you won’t be working on increasing the value, then do make sure that you are not decreasing it either.
3. Don’t hurry to sell, wait for the value of your home to increase
Selling a property too soon can often result in a loss. So if you don’t have a necessary project to spend your equity, then wait for the value of your home to grow naturally. However, while doing so make sure that the condition is solid or better than before. Therefore, you will be at an advantage if the value of your property rises naturally.
Home Equity Loans
Home Equity is a type of loan where the borrower uses their equity in a home as a collateral (security for getting a loan). So basically, people borrow against their equity, in order to get access to a lump sum amount of cash.
Usually, you can borrow for a fixed rate over a fixed period of time after an evaluation of the current market price of your property.
Usage of Combined Loan-To-Value Ratio (CLTV) to Determine Risk
Loan-To-Value ratio is often used to calculate the risk of default in such scenarios. The calculation uses the ratio of cumulative value of loans on a property to the value of a property. Therefore, it includes all mortgages or liens to determine whether a specific person can be lended or not.
CLTV: value of all secured loans ÷ total value of the property
Most lenders require good credit history before lending. A reasonable CLTV ratio is 80% and above where lenders are willing to lend if the borrower also has a history of high credit ratings.
List of Fees
- Appraisal fees
- Originator fees
- Title fees
- Stamp duties
- Arrangement fees
- Closing fees
- Early pay-off fee
- Inactivity fee
- Annual or Membership fee
- Surveyor fee (may be waived off)
- Conveyor fee (may be waived off)
Home Equity Loan Rates
Home equity usually has a payment term of upto 30 years and as of August 2021, they have an average fixed interest rate of 5%. But with a good credit history, these rates can even fall lower.
Home Equity Loans VS Home Equity Line of Credit (HELOCs)
There are two types of home equity loans: home equity loans (also known as closed end) and home equity lines of credit (also known as open end). While both are secured like traditional mortgage against the value of the property, there are some differences between the two:
Home Equity Loans
This type of loan provides a single lump sum amount to the borrower once and for all, that is then later repaid over a specific time period according to the decided interest rates just like a personal loan. However, the interest rate and the payments remain the same throughout the time loan is being paid.
Home Equity Line of Credit (HELOCs)
This type of loan works a little differently. Assume that you have a credit card, and whenever you need something, you can use your card to get your hands on it. Thus, just like that, HELOCs too operate according to the borrowers’ needs. As this type of home equity loan comes with drawing periods, you can use money from your credit like whenever there is a need.
The method is convenient, and often inexpensive. So if you have more than 20% equity in your home, then you can easily qualify for HELOCs.
Advantages of Equity Loans
There are many advantages when it comes to using home equity loans. Here are a few popular ones:
- It is a relatively easy way to obtain a large amount in a short time period, as compared to other loans that may evaluate you first on your credit score history.
- The interest rates are fixed and often lower than others
- It is a “secured loan” since it is secured by your house value
- The loan may be tax deductible, meaning you can lower your tax expenses.
Risks Attached to a Home Equity Loan
While taking home equity loan may be easy and convenient, the idea has some opportunity cost attached with it.
1. You could lose your home
Since you will be putting your home at stake here, there is a good chance that you can end up losing your home if you are not able to pay off your loan on time. Thus, defaulting on a home equity loan is much more complicated than defaulting on a credit card where the only cost might be late fees or a lowered credit.
2. Accumulation of debt
Accumulating debt is never a good idea. This just means that now you need to make additional monthly payments as you will also have to pay interest. Therefore, have a look at how long you will be accumulating this debt for, because the longer it is accumulated, the riskier it is as uncertainty will increase with time.
3. Costs and fees tag along
As mentioned above, there is a list of fees that come along with home equity loans. The rates may vary between 2% to 5% of the loan amount, and there may be costs attached to paying off the loan ahead of schedule. However, these things will be mentioned before you acquire a loan, so make sure to have a look at it and weigh your options.
4. Unpredictable home equity
Nobody wants to imagine their home losing value. Yet home equity can easily rise or fall depending on the housing prices. Just like the 2007 United States subprime mortgage crisis, housing prices can unpredictably boom and then burst if the prices are not equal to the fundamental value.
If such a case occurs, then you will be in trouble if you have taken a loan against your equity. This is because, if the equity of your house falls, then eventually you will owe way more than the fair market value. As a result, instead of utilizing your loan effectively, you will be struggling to pay it off.
5. Impact on credit score
Your credit score consists of multiple factors including: payment history, amounts owed, length of credit history, new credit, and credit mix. Therefore, a large home equity loan can negatively impact your credit score. However, if you regularly make on time payments, then it can instead affect positively.
As a result, since it can go both ways it is important to check credit scores before making a decision regarding home equity loans.
6. Unmanageable payments
While before taking a loan, it often feels like that the mortgage payments are easily manageable. In case of HELOCs, you only need to make interest payments during the draw period. Therefore, if during this period, you only make minimum payments, while drawing a large amount, then eventually later on when the balance will be added to your bill and as a result you might be stuck and find the whole process unmanageable.
Thus, before taking a home equity loan sit back and ask yourself: Can you make regular payments? Is there a worse case scenario where you might lose your job or come across other bills?
When Should you Take out Home Equity Loan
While you should think twice before taking out a home equity loan, here some of best ways you can use your home equity:
*However this does not imply that you should take the loan for these things at all costs. Instead, you should always look for alternatives, and evaluate your own capacity to manage these loans.
1. Home improvements
As discussed above, your equity in a home is directly proportional to your property’s value. And one way to increase your home’s value is through making improvements or upgrading it.
Thus, if you take home equity loan for projects like kitchen renovation, building a new garage, or improving your patio, then it will not only upgrade your living style, but also work as an attractive investment. This way you can easily pay back as the value of your house will increase.
2. Paying off other liabilities
Taking on another debt, just to pay back the previous debt is not usually a good idea. However, in cases where your existing debt has a high interest rate, you can take out a home equity loan (which is usually at a comparatively lower rate) to pay off other liabilities. As a result, you can then save up a significant amount of money every month and pay back over time. But again, before doing so, you need to make sure if it is manageable or not.
3. Pay for college
Colleges are expensive to pay for, due to which people often end up taking student loans. But these loans are usually given at higher rates, and if you opt for home equity loans instead then you will be at an advantage since mortgage rates are lower.
However, before doing so, you need to be sure that you can pay it off before your retirement. Because if not, then student loan will be a better option since that way your child can repay the debt as they later earn.
4. Emergency expenses
Just as the name suggests, emergency expenses often come without a warning. Even though everyone should have enough emergency fund to cover for a few months (ideally 3 – 6 months, but it depends on your capacity), there are times when you need a loan.
This may include examples like medical needs that we aren’t really expecting. And since we aren’t prepared for it, it is okay to take out a home equity loan but there needs to be a plan to pay for it, because if not, then eventually you can fall into serious debt.
When Should you NOT take out a Home Equity Loan
Apart from the factors mentioned in the previous section, you should certainly avoid taking a home equity loan for the reasons mentioned below:
1. Paying for vacations
While a home equity loan may be a cheaper means to pay for your vacations, but considering the fact that it is a luxury and not a necessity, and that you don’t have enough money at the moment, then the smarter approach would be to not take a loan for it.
If you have to take a loan to get hold on something you can easily live without, then this simply means that you are spending beyond your capacity. And as a result, there might be a possibility that you will not be able to pay it back on time.
2. Buy a car
Again, buying a car too comes under the same category of luxury. Especially, if you already have a perfectly working car, but are seeking to take out a loan to buy a bigger/better car. This simply just means that you are taking out a loan for things that aren’t necessary and are out of your monthly income’s capacity.
So therefore, it is better to wait till you are ready to independently buy it without any loan.
3. To help solve monthly cash flow patterns
If you are suffering from low monthly income, then taking any type of loan won’t solve it. Especially a home equity loan where your house will be at stake. Because, if you have less than needed monthly cash flows, then how do you plan on paying back your loan? Therefore, in such a case you need to explore more sources of income, rather than putting your existing equity at risk because you might lose that too.
4. Investment purposes
Using home equity loans to invest in risky markets such as the stock market is also not a good idea. While they might offer higher rates of returns that may exceed the cost of a home equity loan, these investments are also attached with a higher risk.
Thus, if you want to make riskier investments, then it is better you use other sources, like your savings, instead of using your valuable equity in your home.
Are Personal Loans A Safer Choice than Home Equity Loans?
Yes! While both ways you can borrow money for whatever purpose you decide, you may still want to consider opting for personal loans instead of home equity loans.
Even though home equity loans come with lower interest rates, they also use your home as a collateral. This is why they are called “secured loans”, because if you miss your payments, then the lender will have the right to foreclose on your home. However, in case of a personal loan, your credit score might just fall and you may be charged with a late fee if you miss your regular payments. Thus, in a personal loan you don’t have the risk of losing your home, which is why it is always a better option.
In a nutshell, your equity in a home is very important and you should avoid putting it at risk at all costs! Instead, you should try your best to increase your existing equity because it is an asset that will stay with you forever. Therefore, build up your equity in a home for a safe future!