I have been paying close attention to the subprime credit mess. Some articles have really confounded me, when I heard about how some individuals were using their home’s equity, which has now placed them in a precarious situation. In this article, I want to explain how your mortgage works to help you understand your home’s equity. Then I want to go over the use of that equity.
I remember seeing so many ads last year for home equity loans. From a bank’s point of view, this is a great loan, since it is backed by the amount of your home that you actually own. When you obtain your mortgage, the bank has given you a loan to purchase a home. Let us say that the price for the home was $200,000. If you put down $30,000 of your own money, you obtained a loan for $170,000. This means that 15% of the home has been paid for by you. To make the math simple, we will assume that your monthly payment is $1500. This payment consists of generally three parts: payments for the principle, the interest, and the escrow. In reality, your monthly payment can include other costs, but lets stick with these three. The escrow is an account which the bank creates to pay your property taxes and hopefully your insurance. The interest is the amount charged by the bank for loaning you the money over time. Most people are now experiencing problems paying their mortgage because they have adjustable rate mortgages, so when interest rates increase, their payments increase. For this reason, I always advise clients to go after fixed rate conventional mortgages. The principle goes towards paying down your actual loan amount (in this case the $170,000). At the beginning of the loan, you will pay more in interest than you do towards the principal. A breakdown of the payments will be given to you in an amortization table by the lender. For our purposes, we will say that the breakdown is $700 for escrow, $600 for interest, and $200 for principal. These numbers will not be too far from the mark. After a year of making your payments, you will have paid $2400 (12 months multiplied by $200) towards the $170,000 (this is only 1.4%). Here is a secret: pay more towards the principal each month, and you will greatly decrease your interest payments in the long run. Ensure that your lender will not penalize you for this method to reduce your expense. The equity in your home is now $32,400. Now things can go strange with the equity if the value of the home changes. If the price of the home goes up to $240,000, your equity is $72,400 ( $30,000 down+$2400 payments+$40,000 increase in value). However this can go the other way. If the home’s value decreases to $180,000, your equity is $12,400 ($30,000 down+$2400 payments-$20,000). I personally do not know of a lender who will give you a loan for the entire amount of the equity in your home, and the reason for this is the possibility of the change in the home’s value. Unfortunately, this may not have been the case for some borrowers at certain lenders who specialized in the subprime market, according to news accounts.
Many subprime borrowers have been hit with adjustable rate mortgages increasing payments and with the loss of their equity value, which many had borrowed against. I have read stories of homes loosing $60,000 in value, which the borrower had taken out a home equity line of credit against. This means that they have no way of having an asset to exchange for this debt, so by selling the home they have lost the $60,000 for the mortgage loan and another $60,000 for the line of credit.
All of the above is not truly realistic, but this shows you the basic idea behind home equity. So, should you use your home’s equity? This may be an old idea, but I do see my home as my biggest investment to be used later in life. Home equity can be useful when reducing your credit card debt, but you should not then use your cards to load yourself with more debt. This can actually reduce your interest payments, and by not using the cards, your not causing yourself more problems. Another use for home equity can be for a major project, like a kitchen remodel, which will increase your home’s value. Lastly, you can use the equity for periods when you are experiencing financial problems, but you are working to rectify the situation. For example, you have lost your job and the money is running out, you might want to use this equity to help you when you are looking for another job. Never use your equity for a luxury item, such as a pool or boat. Think of using your equity only when it benefits you, not to add more debt to buy something you desire.