Explaining Home Equity

What is the definition of home equity?

The total amount of your outstanding mortgage(s) deducted from the current market value of your home appears to be a relatively straightforward computation. Here's an easy example:

$525,000 = is the current market value of your home
$225,000 = what is still owed on your mortgage
$300,000 = your equity in the home

The loan balance, which appears on the monthly mortgage statement, is one side of the equation that is factual. The second side is less obvious: your home's current market value. Until the home is listed on the market and you receive an offer, a market value is only a guess.

When you make a home purchase, your down payment creates the initial equity of your home. Every mortgage payment you make adds to your equity, although not by very much. Scottsdale real estate is highly desirable with rising property values. That is what can create the largest amount of equity over time.

If you were hit by the real estate bubble, you might have actually lost equity. Hopefully, you didn't lose your house as many others did. But history shows that in other recessions, home equity was not affected. Even in a bad year, which is usually defined as a Buyer's Market, most homes will show some kind of equity increase. 

When I've created a market analysis for homeowners, most of them feel their home should be worth more. They have emotions that don't coincide with the factual data I'm showing them.

You could go online to see what 3rd party real estate websites say your home is worth, but beware! They can be off, and be way off, in either direction. Those websites use a simple computer algorithm and they really don't know enough about your home to give you a concise figure. You need a Scottsdale real estate agent that has access to sold and closed properties in your area within the past 6 months in order to get close to true market value. 

Do you realize that you have the key to creating the value of your home?

Let's think about the subdivision or area you live in. Unless it's rural, there are similar homes surrounding you. They might have been built by the same builder. If there have been any recent sales, then you have a starting point to figure the value of your home.

You don't even need to be carbon copies of other homes in your area. An appraiser will add or subtract for additional or less square footage, bedrooms, bathrooms, etc., from your neighbor's recent sale. They try to get as close to style as possible, but more important to an appraisal is the area in distance and the timeframe of sold and closed homes in that area. 

What could give you a higher value than another home isn't just the size and amount of bedrooms, baths, etc. It is also upkeep. If another home is larger than yours you'd expect it to be higher priced. But if your home is updated with upgrades, is neat and clean inside and out, and the other home has everything original with a lot of wear and tear, your home could be worth more than the larger one. I've seen resale homes that looked like expensive models, and those are the homes that receive multiple offers which can raise the value above list price.

Tapping into your home equity

I have never taken out a 2nd mortgage. Many people have and if done for the right reasons, it can help you down the line. But I've also seen people of all ages treat their homes as an ATM, only to use everything up. Many of these people ended up having to do a short sale or foreclose.

If you really want to tap into the equity of your home, there are two ways to do it.

Home Equity Line of Credit (HELOC)

A home equity line of credit is similar to a credit card in that it allows you to borrow money against your house's equity. Although many home equity lines of credit demand an initial draw, the lender sets a maximum amount you can borrow. You can draw money as needed. The interest rate fluctuates on a daily basis and is normally prime plus a certain amount, but the required payment is usually only interest. The payment is reduced once the loan is paid down, and it can be paid off and re-started as many times as a homeowner desires.

Home Equity Loans (2nd Mortgage)

Many home equity plans limit the amount of money a person can borrow for a specified length of time, such as ten years. The person may be authorized to renew the credit line at the conclusion of this "draw term." If the plan does not allow for renewals, the homeowner will be unable to borrow money after the initial period has passed. At the end of the period, some plans may require full payment of any outstanding balance. Others may allow payments over a set amount of time, such as ten years.

A home equity loan, often known as a second mortgage, usually has a fixed interest rate and a predetermined repayment period, with equal monthly installments. Homeowners that needed to do a short sale on their underwater homes usually had a more difficult time if they had 2nd mortgages. The main mortgage holder had to usually share with the 2nd mortgage holder. Although I was able to get a couple of those through, many others fell apart when I represented the buyer. The process took even longer because of having to deal with more than one lender.

How much of your equity can you get?

The financial institution will not lend 100 percent of the home's equity because they are lending money and using the residence as security. The bank does not want to incur the risk of carrying a loan that is worth more than the house is worth if the house price lowers. As a result, most banks will allow a qualifying homeowner to borrow up to 80% of their home's value. Read that keyword - qualifying. You have to qualify for these loans with income and credit.

It's Critical to Make Good Use of Your Home Equity

Home equity loss is difficult to overcome because it is typically the most valuable asset most people own. It must be spent wisely, and the monthly payments on the loan must be manageable. Only a short-term option is permissible when using equity money to pay off a debt.

There are a lot of excellent reasons to use a home equity loan... and a lot of bad reasons as well. Let's start with smart applications.

1.  Fixing up your home to live in

This might be the most popular reason to use a home equity loan - to put it back into your house. This could be for needed maintenance such as a new roof, which is a large expense some don't have the cash laying around to pay for. New windows are another expense people aren't always ready for. But other reasons will help build your equity up, such as updating your kitchen with new flooring, cabinets, countertops, and appliances. If you're planning on staying in your home, you will enjoy these upgrades for years to come.

2. Fixing up your home to sell

Although my husband and I make some updates and repairs soon after we move into a home, we save other things for when we're ready to sell. We remodeled a bathroom once and my son asked us why we didn't do it sooner. We replied, "because it wouldn't be new any longer." If you've read MLS print-outs, there is sometimes a list of new items a homeowner has in the home. This is to make a home more attractive to buyers when comparing other homes that don't have new windows, roofs, updated kitchens, baths, flooring, etc. If it makes sense, this could be a reason to take it from your home's equity, but be careful. Don't overdo the upgrades. I can help you make that list of what needs to be done to attract buyers, and you might be surprised that it is less than you expect.

3. Sending the kids to college 

Now there's an expense! If you haven't saved up for it using other means, you might have to tap into your home's equity. Know your children well though, it could be a risky move.

4. Helping with your retirement financial needs

You should check the difference between a home equity loan and a reverse mortgage to see which would benefit you more if you need to tap into your equity once you're no longer working. Before you make the wrong decision, speak to a CPA or financial expert.

Don't use your home equity for these

You might regret making a bad decision to take out some of your home equity for frivolous items such as:

1.  Don't buy a new car, boat, or other luxury "toys" using your home equity. Those things depreciate and aren't worth tapping into your home's value. 

2.  Don't use your valuable home equity to help you purchase other investments, which might be much riskier than allowing your home to increase in value over the years. Use money on hand to invest. Start small and keep increasing other investments like purchasing stocks and bonds by using any extra money you have after paying your living expenses.

3. Don't make other lavish and expensive purchases like an in-ground pool with a hot tub or overspend on home upgrades with items that won't increase in value along with your home. You can use your equity to update your home, but just don't go overboard on expensive imported marble that future buyers might not appreciate, for example.

You've built it up, now take care of it

As I mentioned, we have never taken a home equity loan. If we don't have the money for something, we wait until we do. Many homeowners prefer letting their equity build-up for a future sale and purchase of their next home. I have friends that took a home equity loan out to redo their kitchen, and it's beautiful. They have lived in the home for decades and have no plans on ever selling and moving. That will be up to their kids later on. But they can now enjoy that lovely kitchen for years to come.

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P.S. This is an older post and all I had to edit was home prices.