Home Equity

It is the difference between the market value of the home and the balance of all the liabilities on that property.

Home equity refers to the market value of the homeowner's financial interest in their property, free from debt or any other financial liability.

It is the difference between the market value of the home and the balance of all the liabilities (excluding the balance interest amount) on that property.

If a mortgage loan is used to acquire the property, the only equity the homeowner had at the time of the purchase was the down payment made on loan.

Every payment or installment paid on the mortgage loan results in an increase in equity. It also increases when the market value of the property rises.

This equity can also be used to take a one-time second loan or line of credit. The second loan usually is available at a reduced interest rate, and the interest paid on loan is usually tax deductible.

Reasons for separating equity from home

Doug Andrew advises readers in his book Missed Fortune to seriously consider taking as much equity out of their home as possible and investing it elsewhere.

There are three main reasons or benefits of separating equity from home. These are

  • Increased liquidity
  • Safety of principal
  • Rate of return

Let's examine these three reasons in detail.

1. Increased liquidity

The stock market meltdown in October 1987 made the value of liquidity all too evident. Those who have other liquid assets were able to keep their investments. The market bounced back and fully recovered within 90 days, rewarding them.

However, individuals who lacked liquidity were compelled to sell when the market fell, forcing them to take substantial losses.

The equity in the house can be taken out and put into a liquid, secure, conservative side fund that can be utilized to make mortgage payments when necessary. This will help the borrower in preventing foreclosure.

2. The safety of principal

Equity in real estate is no safer than any other investment whose value is set by a market outside our control. The property's value rises or falls in response to economic conditions, which eventually affect equity in the house.

The best security for a homeowner is unquestionably a property that is either completely free of debt or is heavily mortgaged.

When a homeowner has a lot of equity in their property, the unnecessary risk is involved. Investing their equity in many types of assets might significantly decrease this risk. Diversification helps in reducing their risk and increases the safety of the principal.

3. Higher rate of return

Usually, the interest on a second mortgage is lower than on other types of loans. Equity separated from the home can be invested in a safe and liquid fund.

The net return earned after paying interest can be used to mortgage, fund the house's renovation, and fund other requirements like child education.

This money will be safe in a natural calamity, significantly reducing the home's equity.

How to calculate?

It is calculated by subtracting the remaining principal payment on a mortgage loan from the house's current market value.

Here is the formula:

Home equity = Market value of the home - Balance Mortgage

Suppose you want to purchase a house for $300000. Currently, you have savings of $60000, which you use as a downpayment, and you take a mortgage loan of $240000 to purchase the house.

Thus, your home equity is $60000 means you own 20% of your house.

Now consider that the house's market value remains constant, but you have made mortgage payments of $20000 (excluding interest payments). In this case, equity will Increase to $80000 ($300000 - $220000), i.e., 26.67% of market value.

It fluctuates in tandem with the house's market value. Equity increases with an increase in the house's market value and decreases with a decrease in the home's market value.

In the above example, if the house's market price appreciates by 10% from $300000 to $330000, the equity will also increase by $30000.

Equity is also reduced by the second loan taken on the home's equity, called a home equity loan.

Home equity loan (HEL)

A home equity loan, also known as a second mortgage, is a type of loan that the borrowers take by using their equity in the house as collateral.

The loan amount is based on the value of the owner's equity in the home, which is the difference between the market value of the house and the total mortgage due.

Major needs like house repairs, medical expenses, or college tuition are frequently financed with the help of these loans. However, this loan decreases the borrower's actual home equity and places a lien on their property.

Most of these loans demand a decent credit history, a fair loan-to-value ratio, and a combined loan-to-value ratio of 80 %to 90% of appraised value.

A property's combined loan-to-value ratio is calculated by dividing the total principal sum of all mortgages by its appraised value.

This loan can not be used to purchase another property, but it can be used for home renovation and improvement.

Also, according to the Tax Cuts and Jobs Act of 2017 of the United States, interest on the loan is deductible on income tax only when the loan amount is used for home renovation and improvement.

Pros and Cons

Many factors influence why customers favor HEL: They may provide a significant amount of money upfront, are among the least expensive types of debt accessible, and have fixed payments.

Some advantages are as follows:

  1. Lower interest rate
    These loans are backed by security or collateral, and the interest rate on secured loans is generally lower than on unsecured loans.
  2. Fixed payments
    Both the payment and the interest are fixed for the loan. The set payment is predictable and makes budgeting simpler.
  3. Tax benefits
    The interest on the loan is deductible if the loan is taken for home renovation and improvement.

Like any type of debt, these loans have some disadvantages. Some of the drawbacks are as follows:

  1. Risks
    Since the house is used as collateral for these loans, the lender can seize the property in case of repeated payment failures. Additionally, the lenders may auction the property if it already has an unpaid loan.
  2. Closing fee
    Similar to your primary mortgage, closing costs for a second mortgage are high. If the loan is repaid early, an early termination fee may be levied.
  3. Fluctuating interest rates
    Banks and other financial institutions provide fixed and variable interest rates. Choosing a floating interest might be advantageous in markets with dropping interest rates, but it can be expensive when interest rates rise.

Home Equity Loans vs. HELOCs

Two HELs are closed-end (traditionally referred to as a home equity loan) and open-end (also known as a HEL of credit).

In contrast to a HEL, which is often a one-time lump-sum loan with a set interest rate, a HELOC is a revolving credit line with an adjustable interest rate.

The lender establishes an initial credit line limit for a HELOC based on standards comparable to closed-end loans. After that, the borrower will be free to decide when and how frequently to draw against the equity in the home.

Like the closed-end loan, borrowers can borrow up to the house's value, less any liens. These credit lines typically have variable interest rates and a 10-year term. HELOC is a good option for home improvement projects.

Due to the steadiness and predictability of regular payments and knowing how much they owe, some consumers choose the home equity loan over the HELOC. However, a HELOC can be a good option if the person is unsure of the required amount and okay with the variable interest rate.

Key Takeaways

  • Home equity refers to the current market value of an owner's home subtracted by the balance mortgage payment due other than interest.
  • The value of equity increases with every mortgage payment. However, equity value also changes with the changes in market prices. The rises in market price lead to an increase in equity, and a fall in the market price of homes will reduce the equity value.
  • Equity can be separated from the home, providing various benefits to the owner, like increased liquidity, principal safety, and a higher rate of return.
  • HELOCs is different from home equity loan. It provides revolving credit with flexible interest to the borrower against fixed interest and home equity loan payments.
  • Interest under the loan is no longer tax deductible in the united states except when the loan is taken for renovation and improvement of the house.
  • There are different advantages of taking from the house's equity, like lower interest rates, fixed payments, and tax benefits.
  • Risks associated with using the house as collateral, involvement of closing fees, and fluctuating interest rates are drawbacks of taking a second mortgage loan.
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Researched and authored by Dhruv Tyagi | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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