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:
- Purchasing a House
- Refinancing a House
- Taking Cash out of your House
- Dealing with Negative Equity
Home Equity: Purchasing Your Home
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:
- Conventional loans: Lenders offer up to 80% LTV, which means your down payment has to be at least 20% of the purchase price.
- Conventional loans with Mortgage Insurance: Lenders offer up to 95% financing if you pay for mortgage insurance, which means that you need to make a small initial investment of 5% of the price of the house.
- FHA loans: FHA loans require only a 3.5% down payment, but require Mortgage Insurance Premiums, both upfront and annual. FHA loans not only require a small equity position, but also have less stringent credit requirements.
- VA loans: If you have a VA eligibility card, then you can take out a VA loan with no down payment. That means you can receive 100% financing with no equity stake in the house. The VA loan also does not require mortgage insurance.
- Note: Lenders will take the lower value between your purchase price and the appraisal report, which means in certain cases (such as a foreclosed or short sale property) your equity position, based on your market value, will be higher than that based on your down payment.
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.
Home Equity: Refinancing Your Home
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:
- Conventional loans: Lenders offer up to 80% LTV without mortgage insurance and up to 95% with mortgage insurance.
- FHA Streamline: FHA streamline loans for current FHA loans have unlimited LTV. (That means you can have a negative equity position (underwater) on your current mortgage.
- FHA Loans: Your home equity position needs to be at least 3.5% and you will need to pay upfront and annual MIP.
- VA streamline: If eligible, you can refinance your VA loan with no equity requirements.
Home Equity: Taking Cash out of your Home
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.
Home Equity: Dealing with Negative Equity
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:
- If you have a Fannie Mae or Freddie Mac loan, then you might be able to refinance through the HARP 2.0 mortgage refinance program.
- If you have a FHA loan, then look into a FHA streamline refinance.
- If your loan doesn’t fall into those programs read about other possibilities in the Bills.com Harp 3.0 article.
Home Equity: Keeping Track of Your Investment
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:
- Save for a down payment: If you want to save on mortgage insurance costs, then make sure you have at least a 20% equity position in the property.
- Pay down your mortgage: Plan to pay down your mortgage through lower periods and prepayments. However, don’t neglect your other savings, such as your emergency fund, your savings funds, and your retirement accounts. Plan to own your home without a mortgage during your retirement years, when your income declines. Being rent-free and mortgage-free will make your budgeting easier.
- Look for ways to save and increase your home equity by refinancing into a lower interest rate and/or lower period loan.
- Use equity in your house wisely. You can take out home equity loans for remodeling, debt consolidation, paying for education, paying for high price items, or many other uses. Remember to budget carefully and guard your equity for important needs.