I am saving money for a first purchase, but I heard that home equity is only important for refinancing or taking out home equity loans. Explain what home equity is. When should I start thinking about home equity?
Thank you for your question about home equity.
Your home is one (if not the single) most valuable asset you own. Everyone needs a place to live and you can choose between renting and buying. Most Americans prefer to purchase a home, take a mortgage to finance the purchase and gradually build up their equity in the home.
Equity means the amount of money you have invested in the property after paying all the mortgages and home loans. A lender refers to the equity in terms of the LTV (Loan to Value ratio). That means if you have a house worth $350,000, a mortgage for $245,000, your LTV is 70%, and your equity position is 30%. You would have $105,000 of equity in the house (not counting selling costs and taxes). If the price of your property goes up, then you have a lower LTV and a higher amount of equity in your house. If the price goes down (we are all familiar with that scenario), then your equity position decreases and can become negative.
Since your house is such an important part of your investment portfolio, and a necessity, it is important to understand how home equity affects your life. Learn about home equity as it affects you in different cycles of your home ownership process, as follows:
Your down payment is the first equity you put in your home. The amount of down payment is an important factor in determining the amount of loan you receive and the terms of the loan including the interest rate. Here are some general rules regarding down payment and loan sums:
The second step in purchasing a home is deciding the length of the mortgage. Mortgage loans are generally offered up to 30-years, although you can take the loan for other periods including a 10-yea, 15 year or even 40-year period. The longer the period you take, the longer it takes you to build up equity in your house.
The table below shows how much equity you will build in 7 years for a $350,000 house and $280,000 initial loan - 80% LTV and $70,000 equity position. The example assumes that there is no change in the value of your house:
|Length of Loan||Interest Rate||Mo. Payment||Loan Balance||Home Equity|
If you are interested in increasing your home equity position, then you can make prepayments. Most lenders allow for accelerated payments (increase your monthly payment) or lump sum payments.
Refinancing a home is similar to purchasing a house, except the lender does not look at your down payment, rather bases the LTV on a market value of your property. The lender does not use a real estate agent or an online value. The lender relies on an appraisal report or an automated appraisal system.
The same rules apply for refinancing as home purchases, whereby you can find:
If you own a home and want to take out cash, then a home equity loan is an alternative. This means that you are taking out your equity (in cash) without selling your home.
For example if you purchased a home for $250,000 and now owe $90,000 (36% LTV), then your equity position is $160,000 (64%). If for example you want to consolidate credit card and medical debts of $50,000, you can take out a home equity loan for $50,000 and decrease your equity position to 56%. Your LTV (once again assuming that your house value did not change) would now be 44% instead of 36%.
The main types of home equity loans are:
Home equity loans usually require a LTV of 80%, based on the market value of the property, which means a home equity position of 20%. This will vary between lenders and be dependent on your credit worthiness, including your income and debts, credit score and credit history.
You can also look into a second mortgage or a cash-out refinance. A cash-out refinance generally has stricter LTV requirements than a regular mortgage refinance loan.
Since the market crash of 2007-2008, home prices plummeted in many areas leaving many borrowers with negative equity positions. LTV values of 125% - 200% are common in many parts of the United States.
Usually a borrower with a negative home equity position has very limited options. You cannot sell the property without the lender’s approval (a short sale or deed-in-lieu of foreclosure), because there is not enough money to pay back the lender. If the property is sold or foreclosed upon, then you will have a deficiency balance. (Check with a lawyer if your state and/or loan have a non-recourse clause). However, the Obama administration instituted the Making Home Affordable program to help borrowers with a negative equity positions.
Here are some of your refinance options:
Keeping a personal budget, tracking your expenses, and setting financial goals helps you build your equity and net worth. For most, your home is an important part of your investment portfolio. Just like any investment, we don’t know how the market place will affect its future value.
However, it is important to: