What is Equity?

When we talk about equity, we are usually talking about the equity in your home. Equity is essentially the value of your ownership interest in the property. For instance, if your home is worth $200,000, and you owe the bank $150,000 on your mortgage, your equity in the property is $50,000. As you pay off your home, your equity in the property grows. When all debts are paid, the homeowner has 100 percent equity stake in the home.

Why Leverage Home Equity?

You can use home equity to your advantage when you use it wisely and judiciously. You should not use such a loan for purchases. Good reasons to take out
home equity loans include financing a college education or performing home improvements and repairs.

While it is sometimes advisable to use your home equity to consolidate credit card debt, you must dispose of your credit cards for it to work. If you take out home equity to pay off credit card debt, and then keep amassing more credit card debt, you are headed for financial ruin.

How Value Effects Equity

If the value of your home drops, so does your equity. Let’s take our example of a home valued at $200,000 with a $150,000 loan. If you only paid the interest on the loan and not the principle for five years, and the value of the home dropped due to market conditions, you would lose equity. Conversely, if the value of your home increased, so would your equity. It is also possible to end up with negative equity if the value of your home falls below what you owe. In that case, if you wanted to sell your home, you would actually have to come up with the money to pay off the balance.

For instance, at the start of the loan, you have 75% equity in the home, or $50,000. If after five years of paying interest only, the value of your house drops to $140,000, you lose all of your equity in the house. If you were forced to sell, you would have no money to make a down payment on a new home and would actually have to pay the bank another $10,000 to pay off the loan. Many find themselves in this situation today, since the 2007 real estate collapse.

How to Leverage Your Home’s Equity

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To leverage the equity in a home, you take out a home equity loan. If you apply for a line of credit, the bank will ask for a home appraisal to establish the amount of equity you have in the house. The appraised value, minus the amount you owe on the primary mortgage and any other loans in which you used the house as collateral, is your amount of equity.

In recent years, home equity lenders were loaning homeowner more than the home was worth, sometimes extended credit up to 110% of the home’s value. It is considered more prudent for lenders to calculate 75% of the home’s value, subtract any outstanding debt, and then offer a credit limit up to the remaining amount.

Lenders look at more than just your equity stake in the house when considering a home equity line of credit. They will look at your employment history, credit record and other financial obligations before approving a line of credit.

In most cases, a home equity loan must be repaid within a fixed time, like ten years. Once the ten years has passed, the homeowner can no longer make equity withdrawals and must only pay back the load every month. When taking a home equity loan, be careful about any language in the contract that may require full payment at the end of the withdrawal period. This is called a “balloon payment.”

Look for a repayment period of ten years or be ready to pay everything you owe at the end. Some homeowners must take out a loan from another lender to honor a balloon payment and secure more time to pay back the loan. Understand that any amount owed on an equity line must be paid in full when and if you sell your home.

You should also do your best to secure a fixed rate on a home equity line of credit. You may pay a higher rate than on a variable rate plan, but you will have a more dependable monthly payment. If you choose a variable rate, look for a plan that puts a cape on the amount the rate can increase from month to month and from year to year.

Establishing a line of credit on your home equity has many of the same closing costs associated with getting a first mortgage. There are appraiser’s fees, origination fees, application fees, attorney fees, title search and insurance, and you may decide to pay points for a lower financing rate. Other fees may also apply during your equity plan. There may be maintenance fees or transaction fees every time you access your line of credit.

How a Home Equity Line of Credit Works

Home equity loans often function like credit cards. In fact, many home equity lenders issue a credit card or checkbook to the homeowner to make withdrawals from the line of credit easier. The homeowner pays a minimum amount each month and is wise to pay off as much as he or she can every time a payment is made.

Some lenders require you to withdraw a minimum amount each time you access your line of credit, such as $300. These plans often use checks instead of credit cards for withdrawal. Credit card plans general do not place minimums on the amount you can withdraw at once.

Second Mortgages

A home equity line is not the only way to leverage the equity in your home. You may also consider taking out a second mortgage. With this kind of loan, you will pay a fixed monthly payment over a set number of years. You will not be able to make additional withdrawals and your monthly payment will not change, except for any changes on interest rates for a variable interest loan.