What is Home Equity? Why is it Important?
At first glance home equity is a very simple calculation — the total amount of mortgages owed subtracted from the current market value of a home.
For example:
Current Home Market Value $325,000
Existing Mortgage Balance $225,000
Homeowner Equity $100,000
One side of the equation is well defined, and it is found on the monthly mortgage statement; the loan balance. The other side is less obvious — the current market value of the property.
Homeowners can make savvy assessments about their home’s current market value by following the sales of similar properties in the neighborhood. Limited value should be put in websites such as Zillow and Trulia, which provide inaccurate and outdated estimates. The most accurate measurement requires a having the home professionally appraised or I can provide a comparative market analysis. It is a complimentary service that I offer my clients. The bottom line — your home is worth as much as someone is willing to pay for it.
Creating Value is in Your Hands
Maintaining the condition of a home is vitally important to retaining and increasing value. Homes are judged against their peers: how they compare to similar homes in the neighborhood. Another way to retain value is to not overbuild your home for the neighborhood, since it is rare to ever recoup the money spent if you exceed neighborhood value. Keep up the landscaping and exterior -do the little things to add curb appeal.
Another complimentary service I offer clients, is providing feedback on how improvements will impact future resale value. Having remodeled multiple homes, I can serve as a resource and provide referrals of service providers. Send me an email if you would like me to send a referral directory!
Putting Home Equity to Work
Home equity represents the largest single asset of millions of people, and because it represents so much of an individual’s net worth, it imperative to treat it with respect. Home equity is not a liquid asset until a property is sold, or unless it is borrowed against.
There are two types of loans that tap into homeowner equity as collateral.
Home Equity Loans
Many home equity plans set a fixed period during which the person can borrow money, such as 10 years. At the end of this “draw period,” the person may be allowed to renew the credit line. If the plan does not allow renewals, the homeowner will not be able to borrow additional money once the period has ended. Some plans may call for payment in full of any outstanding balance at the end of the period. Others may allow repayment over a fixed period, for example, of 10 years.
A home equity loan, sometimes called a second mortgage, usually has a fixed rate and a set time to pay it back, generally with equal monthly payments.
Home Equity Line of Credit
A home equity line of credit is similar to a credit card. The lender sets a maximum amount you can borrow, and you can draw money as you need it, though many home equity lines of credit require an initial draw. The interest rate varies daily, and is usually prime plus a set number, but the required payment is usually interest only. Once the loan has been paid down, the payment is reduced, and it can be paid off and initiated as many times as a homeowner requires.
How Much Equity can be Accessed?
Since the financial institution is lending money and using a home as collateral, they will not lend 100% of the home’s equity. The bank does not want to take the risk that if the house price drops, they would be carrying a loan for more than its market value. Therefore, most banks will allow a qualified homeowner to borrow approximately 80% of their equity.
It’s Important to Use Your Home Equity Wisely
Because it is likely the biggest asset most people have, using home equity should be carefully considered. It must be used in prudent ways, and the payments against the loan must be affordable. Using equity money to make the loan payment is only acceptable for a short-term solution.
There are number of good reasons to use money from a home equity loan… and some really bad ones. First, let’s cover smart uses.
1. Invest in Your Home
The best way to use the money is create more equity in the home. Among the very best returns on your investment (ROI) include kitchen and bathroom remodels, adding square footage or an extra bath, enhancing curb appeal and repairing/keeping the existing structure sound. Making prudent investments in your home is a wonderful win-win: you enjoy the upgrades and the repairs can add value to the home.
2. Invest in your Children’s Education
Using your home equity to finance a child’s higher education may be the greatest payoff of all. Not only is the rate much lower than a student loan, it is an investment in the child’s future.
3. Supplement Retirement Needs
Older homeowners spent their working lives paying down their mortgage. At retirement, when monthly income is reduced, a home equity loan could pay for a dream vacation or an unexpected major expense.
4. Augment the Impending Sale of a Home
If you’re planning to sell soon, a home equity line of credit may be the best way to finance improvements, and you can pay it off entirely when you sell. Investing wisely on upgrades and repairs may even reap a profit on your investment.
5. Use as a Down Payment for a New Home
It is well-known in the Seattle Area Real Estate Market, that if your home is vacant and staged, you not only get the highest sales price, but it is also the least disruptive of day-to-day life.
You need a conservative and savvy team of a lender and real estate consultant in order to assess the risks and rewards of this home buying strategy. I have helped many clients seamlessly transition from their old house to new, with the best possible outcomes in both their purchase and sale.
Here are some examples of some not very wise choices.
Adding luxury amenities like a swimming pool, a hot spa, lavish landscaping, expensive appliances and exotic countertops and flooring rarely pay off.
Purchasing a car or boat or most any personal luxury items is a poor use of the funds, since these items quickly depreciate in value.
Also stay away from using money on risk-heavy investments. Financing stock purchases, start-up businesses and paying routine bills is not financially smart. If you cannot afford to purchase those items with available funds, using equity from your home means they should not be in your budget.
You should treat a home equity loan as an investment and not as extra cash when making financial decisions. If your intended use of the money doesn’t pay you back in some way, it is not the best use of your valuable equity.