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Home equity is where homeowners gain wealth through living in their home. Equity can go up when the property value increases, and it can go down as you pay your mortgage. You can think about it as the part of your home that you truly own in comparison to your mortgage.
It sounds complicated, but it’s really not. We’re going to break down equity and help you answer the question of “how does equity work?”
What Is Home Equity?
First, think about how much your mortgage was originally financed for and then look at your current balance. The difference is the initial equity that you have in your home. To give you an example, imagine you purchased your home for $$, and your current remaining balance is $$. That gives you $ in equity, but it doesn’t stop there.
Now, imagine that you purchased your home five years ago and since then, your property value has increased to $$$ for your home. That means if you were to sell your home, you could ask for $$$ because it reflects the current property value.
Take that $$$ and subtract your current balance on your mortgage, the $$ , and you end up with a difference of $. That $is considered to be your home equity.
How Does Home Equity Work For Me?
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To build your home equity is going to take time, and it can just as easily plummet like many experienced when the housing bubble burst all those years ago. Like everything else, though, if you can hold on to your home through the rough patches, the value will go up again eventually.
Equity can be compared to something like a 401k or savings bonds. The money is there, but you can’t spend any of it without some work. As an example, you can borrow against the equity in your home through something called a home equity line of credit or a home equity loan. Anything borrowed is added to the existing principal.
Another way to access the funds is to sell your home or other property. Being able to access your funds is helpful in case of an emergency or when you need to make immediate improvements to your home. Bonus – you can use home improvements as a tax deduction on your tax return.
What Are The Risks Of Borrowing Against Home Equity?
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A line of credit and home equity loans put your home down as the collateral to borrow the money from the bank. That’s a serious commitment to paying off the loan because if you were to become unable to make payments, your house could go into foreclosure.
Something else to consider is the way the property value changes. If you borrow $ against home equity, then your remaining balance of $$ climbs to $$$ that you will have to pay. If your home value drops to $$$, then you owe more than the home would be worth.
If you have to move or sell your home when you’re in that kind of scenario, then you are going to have to face the possibility that you may lose significant money on the sale. The result could be that you won’t be able to move as you wanted.
Obligations for Lines of Credit, Home Equity Loans, and Mortgages
By now, you understand that a line of credit or home equity loan is going to be money taken out against your home. Like your original mortgage, the ramifications are huge if you can’t make the payments. If you’ve ever heard of multiple mortgages, the additional loans on top of the original mortgage are what those are referring to.
The good news is that home equity loans have a much shorter term compared to mortgages. While a 15-, 20-, or 30-year mortgage are standard fare for mortgages, a loan or line of credit is typically going to have a repayment term of just a few short years.
Having the money available in home equity isn’t enough to get a loan or a line of credit. You will have to have your credit checked, and your debt-to-income ratio will also be verified. If your bank or other lender deems you to be worthy, then you’ll qualify for one or the other.
What Is A Home Equity Line Of Credit?
Most people have credit cards and understand that you use a credit card to make purchases that you have to pay off later. A home equity line of credit functions much the same way. They have draw periods or a limited amount of time that you can withdraw funds up to the approved limit.
You can usually choose between an interest-only period or a period where you can pay interest as well as the principal. The first is going to take you longer to pay back while the second option is going to allow you to pay your credit line back at a faster rate.
At the end of the draw period, you have to pay everything back, and you are not likely to be able to renew your line of credit until after it has been paid. You may also be stuck with an adjustable interest rate which can impact the amount you have to pay back.
What Is A Home Equity Loan?
A home equity loan gives you a lump sum that is due back at a fixed rate over a pre-determined time frame. It works similarly to a personal loan except the collateral is your home. You will be expected to pay a set monthly amount to the tune of an included compound interest rate.
Compound interest means that you’ll be paying interest on your interest with each subsequent year. It is not unusual for a loan of $ to result in paying back closer to $ once everything has been paid back.
Home Equity Line Of Credit Or Home Equity Loan?
Deciding if you want a line of credit or a loan is going to depend on why you want or need the funds. If you need money to maybe pay for an extravagant event, like a wedding, and don’t intend to borrow anything else, then a loan is going to be best. It will have an adjustable rate, but at least you’ve only pulled what you need.
On the other hand, let’s say you’re going to help your son or daughter pay for their college tuition every semester. With that in mind, you may want to get a line of credit that you can draw from and pay back as needed for every semester. It allows you to borrow the money as you need it. Smaller amounts that are borrowed periodically also end up costing less than a loan because you can pay them back faster.
What Questions Do I Need To Ask?
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When you’re asking yourself how does equity work, you also need to ask yourself a few questions to help you decide how to best use your equity. Decide when you need it and for how long you need to have access to the funds. Credit card consolidation is more of a short-term purpose while college tuition is more of a long-term scenario.
You’ll also need to determine what kind of monthly payment you’ll be able to handle as well as whether or not you can control yourself if you have an open line of revolving credit. Don’t forget to make sure you know your rates, repayment periods, and any other possible consequences.
Missing payments or not paying at all can result in losing your home, so you need to be sure you can reliably make the payments. There may be other restrictions in place, too, like not being able to rent out your home for the duration. Whatever you do, make sure you read the fine print.
Going Forward With A Line Of Credit Or A Home Equity Loan
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If you can justify, and with good reasons, why you should dip into your equity, answering “how does equity work” can help you make an informed decision. It’s important to know the possible consequences as well as the benefits of going forward with a home equity line of credit or a loan.
Ask questions, research your market value and current creditworthiness, and then you’ll be better equipped with necessary knowledge before entering a repayment agreement you may or may not be able to live with.
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There are many ways to finance investment properties. If you’re not paying all-cash for a property, and you want to utilize leverage to greatly increase your prospective ROI (return on investment), you’ll find many options available to you. Which one you choose is a matter of personal taste. And deciding among different investment property loans available, that will suit your temperament and pocketbook, will be critical to your bottom line.
investment property loans from banks traditionally require at least thirty percent down by the buyer. So I was able to leverage an additional ten percent by going with the seller financing. This was a great way to get a business loan for rental property.
benefits of an unbelievably low monthly payment, and resultant high cash flow – and even greater net income. This four family house quickly became a huge cash cow for me. And I had plenty of time in which to refinance to a traditional loan. So while I ended up paying about ten percent higher in market value than the property was worth, the difference was more than made up for (while I held the property) in net cash flow income and capital appreciation when it came time to sell. So my advice: if you can find seller financing, take it. And don’t be afraid to give the seller “their” price” in return for “your” financing terms. It could end up being a major financial windfall for you in the end.
are usually at least double conventional mortgage loan rates. And their points charged (pre-paid interest) can be triple or quadruple conventional points charged.
due within 1 to 3 years. In all but rare instances, hard money lenders require being in the first mortgage position, so they can get their money out first if you default.
a minimum of 30% down in most instances. In that case, you’d be obtaining a loan of 70% of the purchase price. Your loan-to-value ratio (LTV) would therefore be 70%. When buying investment property, you’ll usually want to try to obtain the greatest return on investment (ROI). Leverage (also known as cranking) is one of the ways you can purchase multiple properties over time, and thereby maximize your ROI. Depending upon your credit rating, as well as the type of property you’re purchasing, the down payment required may be higher, and could go up to 50% – and therefore your LTV would be a low 50% as well. In addition, the points charged on the loan (pre-paid interest) are roughly twice as high as for a conventional home loan.”
homes or apartment buildings with at least five units in them, the you’ll definitely need a commercial loan from a lender. Lenders have separate divisions to evaluate and extend credit on these type properties. Since commercial properties are much more specialized, their inherent risk need to be evaluated as a niche within most banks. Unlike conventional residential mortgages, you can expect that underwriting requirements will be much more stringent by comparison. For example, a commercial lender will be poring over your financial statements with a fine toothcomb, and you can certainly count on much more scrutiny of your assets and income, as well as the existing income statement of the property you’re considering purchasing. Also expect rates and points to be higher than standard residential loans.
way of financing. Interest rates are usually as low as you can obtain from any lender. Second, the interest is tax-deductible as a business expense. And third, you can choose to make interest-only payments monthly on the outstanding balance, usually for a period of ten years, knowing that you’ll have a balloon payment looming down the road. Most times, the balloon will be incorporated into a second ten year payback period, where you’ll be making monthly principal and interest payments. In this way you can utilize the equity in your home to create a credit line for further property investments. You’ll find this a great way to finance further investment property acquisitions. Also, you can structure the loan as a revolving credit line. So when you sell a property, you can pay off the credit line. Then you can take it out again when you’re ready to purchase the next house.
of living with a balloon mortgage. If you’re going to invest in commercial real estate, a balloon payment mortgage will be a given. And in most residential real estate deals where the owner is offering a mortgage, you can also expect a mortgage balloon payment as well. So, what is a balloon mortgage you might ask? The simple answer is that, at the end of the mortgage term, you will still owe a large chunk of the principal on the property you purchased. The balloon mortgage definition is that the balance will need to be paid, on time, at the end of the term in the form of a large, “balloon” payment for this balance due.
are not like most residential bank mortgages that are self-amortizing, where you pay some amount of principal and interest for either a 15 or 30 year term, every month, like clockwork. Instead, to keep monthly payments reasonable, a 15 or 30 year amortization schedule may be used, as in residential mortgages, however the actual term of the mortgage is much shorter, say between one and ten years. The most common ones I’ve seen usually are in the three to five year range. So obviously, if you’ve been making monthly payments using a 30 year amortization schedule for a 5 year balloon mortgage, quite a lot of principal will be have to be paid off at the end of the term. And this remaining balance is known as the balloon payment.
would go out and refinance the property with a commercial bank for this remaining amount, your balloon payment. This is extremely common, and a very accepted practice. Most banks are amenable to offering refinance mortgages because by the time your first mortgage is due, you’ve increased your equity in the property substantially – a fact that only helps you qualify even more for a commercial bank’s underwriting standards. Over a five year period, you may be able to build up an extra ten to twenty percent in equity valuation on your investment property. And banks traditionally want to ensure that you have at least twenty-five to thirty percent of your own funds already invested when they go to offer you any mortgage on an investment property.
noted how “any money you don’t have to put up yourself when you buy investment property offers you the opportunity to increase your leverage on the purchase. And if you don’t have to borrow from a bank (or worse, a hard money lender) then you will be saving your credit line possibilities for further down the road. And if an owner is willing to take back mortgage paper for at least some part of the purchase price, you will be ahead of the game. Even if that amount is small, or not a first mortgage, it will benefit you. Every little bit of leverage goes a long way. Of course, if you can obtain a first mortgage from the seller, even better still.”
simply holding out to obtain seller financing. But if you do manage to come across a willing seller offering some amount of owner financing, by all means, don’t pass it up.
excellent income producing property. And you want to jump on it by making a quick offer. I have seen some hard money lenders who don’t simply offer high interest rate, short term loans. I have discovered, and run into, some who would like to become your “partner.” One could say that the sheer hard money definition is like that of a loan shark. Be very careful if you find any hard money lender offering financing, but requiring a “back-end” amount when it comes time to sell your property. I had the occasion to inquire of a hard money lender once, and they were quoting me terms that were gangster-like in nature. These included: only financing fifty percent of the purchase price, a ridiculously high interest rate, with a two year balloon mortgage. Oh – and they wanted fifty percent of the gross profit upon the sale of the property when it came time for you to sell. Obviously, any novice investor should stay away from this kind of predatory hard money lender.
here how “the average hard money investment property loan is supplied with capital put up by private investors – usually as a pool of money that is used to drive much greater profits for its investors. This private capital is traditionally unregulated…many consider hard money lenders as sharks feeding off the misery of those in bad financial straits. As a property investor, you will certainly need to approach any hard money investment property loan with a great deal of caution and foresight prior to signing on the dotted line.
how “while paying all cash for a property is the “safe” way of investing, it provides no way to leverage your financial strength. Assuming you could not obtain conventional financing, hard money lenders offer the next best alternative to all cash deals. While your cash flow will be severely impacted because of the relatively exorbitant interest payments on hard money loans, even a small positive cash flow will yield great leverage over several years of making timely payments on the loan. Remember, besides the cash you put up on the property as your down payment, you will be paying off the principal on your hard money loan each month – thereby helping to increase your return on investment (ROI). Over several years, a small positive cash flow will yield much greater ROI’s than an all cash purchase would.
usually come due within 1 to 3 years. In all but rare instances, hard money lenders require being in the first mortgage position, so they can get their money out first if you default.
the consequences in case of default. The hard money lender takes on the increased risk of borrowers with less-than-stellar credit. For this, they are able to charge exorbitant interest rates, with onerous terms, and even more Draconian conditions if the borrower defaults.
