You can’t turn on a radio or TV news program without hearing about how the financial crisis has hurt the amount of equity individuals have in their home. You may even hear terms such as negative equity or hear advertisements for home equity loans. But what does all of that mean?
What is equity? Those proficient in the English language will note the root of the word “equity” is equal. The equity in your home, therefore, is the amount of money it would take for your home’s value to equal the amount you owe on it. For example, if your home is worth $200,000 and you owe $150,000 on your mortgage, it would take $50,000 to make that amount equal. Because the homeowner, in this case, has the larger amount, he or she would have $50,000 of equity. Conversely, if the home is worth $150,000 and the mortgage is $200,000, the amount to make the two sums equal would still be $50,000, but since it’s a shortfall, it would be negative-$50,000 of equity.
What is a home equity loan or line of credit? The Federal Reserve Board explains that a home equity line of credit is a “form of revolving credit in which your home serves as collateral.” Because it’s a line of credit, you can choose when to take out money and how much to take up to a certain percentage of home equity. A home equity loan is sometimes referred to as a second mortgage. Home equity loans usually have a shorter payback period than a standard home loan. More goes into obtaining a home equity line of credit than the amount of equity in your home. The lending institution evaluates one’s ability to pay the loan back by doing a credit check, evaluating current income levels, looking at a potential borrower’s debt to income ratio and forecasting home value trends in the area.
What are the costs of using equity? Having equity is a good thing. One must, therefore, proceed with caution when using home equity as a personal line of credit. The cost of establishing a home equity line of credit include a property appraisal fee, an application fee, upfront charges, closing costs and interest paid. If a home equity loan is not paid back, the bank can foreclose on the property.