- Real Estate
Home Equity Loans and Home Equity Credit Lines
For many, buying a new home is a wonderful experience and there are a number of financial and tax benefits that can be reaped by investing in real estate. Most homeowners do not have the money to purchase a home upfront, so take out a mortgage on the property.
A mortgage is simply a loan that covers the cost of the home and land, using the property as collateral against the amount of the loan.
Over time, a homeowner will build up equity in their home, which they can later use to receive a home equity loan or a Home Equity Credit Lines. Both of these financial products can be very beneficial, but like any type of debt, it is also possible to get into trouble if you are not careful.
What is Home Equity?
Equity is used to describe how much money a person has already invested in their home. The formula for home equity is simple, just take the value of the home and subtract the remaining balance of the home loan. This figure represents the equity of the home.
For example, if you bought a home for $100,000 and paid a $10,000 down payment, you would have $10,000 in equity.
In the above example, the equity is based off of how much the individual paid for the home and the total principal of the mortgage, however if the value of the home rises, so does the equity.
For instance, say five years later, you have paid down an additional $20,000 on the principal of the mortgage. The balance of the mortgage is now $70,000. Since depending on the area, real estate will often increase in value, lets say the home is now valued at $130,000. With this increase in value, the equity also increases, so you would now have $60,000 in equity, even though technically you have only paid $30,000, excluding interest, for the home.
Is Home Equity Like Money in the Bank?
Now, many people and some less than reputable lenders, would have you believe that $60,000 in equity is money in the bank. It is important to remember, however, that you would have to sell the home for the full $130,000 to receive your equity.
Depending on the area where the home is built the value of the home may increase rapidly, but it can also decrease and there is no guarantee that the home will sell for its full market value.
For many, having an increasing level of equity is a nice assurance that when it comes time to sell the home, the homeowner will make some money, which can be reinvested.
However, it is also possible to borrow against the equity of the home, receiving either a home equity loan or a home equity credit line.
What is a Home Equity Credit Line?
A Home Equity Credit Line, on the other hand, is basically just a credit card, with a limit that is based off of the equity of the home. If you use the home equity credit line, then you would have to pay it back just as you would a credit card, often with an interest rate as high as that of a credit card.
Waht is a Home Equity Loan?
A home equity loan, is a loan that is offered for the equity, or part of the equity, of the home. The homeowner will receive a single lump sum, which is then paid off monthly over a set period of time.
Risks of Home Equity Loans
While for many, a home equity credit line or home equity loan can provide an important boost, paying for a number of expenses, it is also possible that you might run into trouble if the value of the home decreases.
During the 1990's there were often times when a homes value increased by 20% every year. This rapid increase is often thought to be a cause of the housing market bubble, which many feel was partially caused by artificially inflated home values. As a result of these rapid increases, home equity credit lines and loans rapidly became popular, with people using them not only to invest in their home, but also for things like college loans and regular credit card debt.
Often, lenders would offer a home equity loan when the individual bought the home, using the home equity loan as a down payment. This resulted in people having both a mortgage and a home equity loan, at the same time. Many of these loans were considered subprime, which are basically loans that have a higher mortgage rate than normal, which increases every few years. When the interest rate increased, many found they were no longer able to afford their debt load, which was coupled by decreases in home value during 2006 – 2009.
So, while a home equity loan or home credit line can be a very important asset to the homeowner, it is also possible to get into trouble with this type of loan.