When the real estate market is booming, it leaves behind home values that are far greater than the price paid for them. Their owners are a direct beneficiary of this increase, and can realize a substantial growth in the equity they have in their homes.
It is also safe to say that for the vast majority of Americans; their home is usually the single largest asset they own. When the price of a valuable asset increases, the owner's net worth increases too.
If a home has grown in value over the years, the owner is probably eligible to take out a home equity loan. These loans are sometimes referred to as a second mortgage, since it's also secured by the house.
A home equity loan is based on the principle that lenders will allow owners to borrow against the value of their home. The amount the owner is eligible to borrow is called the net value, or true equity. The overall concept goes something like this:
Home equity typically increases over time in two ways; as the homeowner pays down the outstanding principal on their mortgage, and as the home's market value increases. Generally, lenders will allow owners to borrow up to 80% of the equity they have in their homes.
Rising home values, coupled with interest rates near historical lows, has resulted in the growing popularity of home equity loans. Just like mortgages, these loans can have fixed or variable interest rates and terms that extend to 30 years. The following example demonstrates this point:
Let's say that Sam's home would sell for $300,000 in today's market; eventually the number would be validated by a professional appraiser. Most lending institutions would allow Sam to borrow up to 80% of the home's appraised value, but let's be conservative at 75%. So in this example, Sam could borrow $300,000 x 0.75, or $225,000.
Like most Americans, Sam has an existing mortgage on the home. The remaining principal on that loan is $125,000. This means the maximum size of the loan would be calculated as $225,000 - $125,000, or $100,000.
Now the thought of borrowing $100,000 might be tempting to many because the money could be used to pay for a number of luxury items. Unfortunately, if the money is borrowed, it needs to be paid back. The loan is secured by the home; so going into default could mean the house is lost to a foreclosure proceeding.
Here are a couple of tips that can help borrowers avoid this type of trouble:
There are laws to protect borrowers when entering into these types of agreements. The Truth in Lending Act requires lenders to disclose important terms and conditions, loan origination costs, charges, payment terms, and other features of the loan; including the Annual Percentage Rate (APR).
The APR takes into consideration not only the interest rate charged, but also mortgage points and other expenses such as loan processing fees. When comparing various offers, the APR should be carefully weighed along with the features of each loan.
Before contacting a mortgage company, bank, or lender, borrowers should run through some "what if" scenarios. This website has an extensive line of online mortgage calculators that can help with this process. These offerings include a blended rate mortgage calculator that can help users to visualize the financial impact of paying back two loans at the same time.
We offer a mortgage comparison calculator that can help users evaluate different loan offerings on the marketplace. Finally, we also have a maximum mortgage calculator that allows users to figure out if their family or household income qualifies them for a loan of a given size.
About the Author - Home Equity Loans: A Primer