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Home Equity

Updated on January 5, 2024
Article byPrakhar Gajendrakar
Edited byCollins Enosh
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Home Equity?

Home equity refers to a property’s current market value after subtracting any associated liens. Home equity is the difference between the prevailing market price and the pending loan amount at a particular point in time.

Home Equity

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When an individual purchases a house on loan, they repay the amount in the form of monthly installments. Simultaneously, the market value of the property rises. The more an owner pays off the loan, the more their equity. Thus, over time, the borrower’s equity rises—till the lien is completely paid. Once the loan is paid completely, the borrower has 100% home equity.

Key Takeaways

  • The home equity amount is determined by subtracting the pending loan amount from the property’s current market value.
  • Home loans are a common source of wealth creation—real estate or land purchases.
  • When a house is purchased by paying interest rates on home equity loans, a minimum of 20% down payment is required.
  • Borrowers are advised to pay as big a down payment as possible. By doing so, borrowers can shorten the loan period and diminish monthly installments.

Home Equity Explained

A borrower takes a home equity loan to buy houses and real estate. Of course, everyone dreams of owning a piece of land. But most low-income and middle-income individuals do not have the funds to purchase. As a result, they’re unable to pay cash upfront. This is where home loans come in.

Initially, the borrowers make a down payment of 20% of the total price, and the remaining 80% is loaned by a bank, lender, or financial institution. Although not mandatory, it is advised that borrowers must try to pay as big a down payment as possible. By doing so, borrowers can shorten the loan period and diminish monthly installments.

This arrangement is called equity because the banks treat the newly purchased property as collateral. If borrowers fail to repay, the bank can always confiscate the property. Since there are multiple options, borrowers must research and choose the lender that offers the lowest interest rates on home equity.

Loans are a convenient provision if borrowers repay in a disciplined manner. But it is not a trivial matter; missed installments stack up on each other and can become an impossible liability in no time. Moreover, regular repayments are crucial due to credit scores. Poor credit history makes it that much harder to acquire future loans.

Home loans require a minimum credit score of 621. Even so, borrowers can work around it by having a low debt-to-income ratio, a high income, and a down payment of at least 15%. However, their fine print is involved in drafting terms and conditions offered by lenders. Therefore, borrowers must carefully determine the type of interest applied on loans—fixed or floating interest rates.

For example, the Bank of America offers home loans with a 6.650% variable APR. The Annual Percentage Rate (APR) is the annual rate a bank or financial company charges on an investment or loan. It is a method of calculating a loan’s total cost over one year.

What Is HELOC ?

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There is a prolonged home equity loan vs HELOC debate as to which is better. There is only one difference, with home loans borrowers receive a single lump-sum payment, but in a home equity line of credit (HELOC), borrowers can withdraw multiple times.

Also, home equity borrowers are responsible for paying property taxes despite not completely owning the property yet.

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Home Equity Calculation

To calculate home equity, two important factors need to be determined—the loan amount left (the total money a borrower owes to the lender) and the property’s current market value. Therefore, we subtract the loan amount left from the market price to determine the borrower’s equity.

Let us look at a calculation example.

Let us assume that the value of a particular home is $40000.  An interested buyer makes a 20% down payment ($8000) and takes a loan for the remaining 80% ($32000). The loan has a tenure of seven years; the borrower is required to pay monthly installments.

After three years, $20000 of the loan amount is left. Simultaneously, the market value of the property shot up from $40000 to $50000

Applying the given values to the home equity formula, we get the following:

  • Equity = Market Price of Property – Pending Loan
  • Equity = $50000 – $20000
  • Equity = $30000

Therefore, the borrower possesses a home equity of $30,000.

Examples

Let us look at some examples to understand home loans better.

Example #1

Richard bought a small house for $90000. He deposited 20 percent, amounting to $18000.  the lender offered a loan for the remaining $72000. Therefore, at the time of purchase, Richard possessed a 20% equity in the House.

Richard paid mortgage payments on time. Within three years, the entire loan amount diminished to $54,000. Meanwhile, the market value of the house rose to $120000.

Thus, after three years, Richard possessed the following equity:

  • Equity = Market Price of Property – Pending Loan
  • Equity = $120000 – $54000
  • Equity = $66000

Example #2

Let us look at an alternate possibility.

The market value of a property does not increase all the time. Let us assume that the market value of Richard’s house plummeted from $90000 to $81000.

Again, Richard brings the pending principal amount to $54000 by repaying regularly.

Based on the given values, Richard’s equity in the house is as follows:

  • Equity = Market Price of Property – Pending Loan
  • Equity = $81000 – $54000
  • Equity = $27000

Pros And Cons

Let us look at the pros of acquiring a house loan.

Home loans also have the following cons.

  • Banks readily offer home loans because the newly acquired property is taken as collateral. This arrangement, though, is risky for the borrowers.
  • Characteristically home loans have a long tenure—ten to twelve years—it is a potential risk. Therefore, borrowers must ensure a regular source of income well into the future.
  • Acquiring a home loan is challenging for borrowers who have poor credit histories.
  • If borrowers fail to make regular repayments, they risk losing the entire property, including the initial down payment.
  • Home loans are notorious for exploitative terms and conditions—there is a lot of fine print. Many borrowers unwittingly end up acquiring a loan with a floating interest rate. Thus they end up paying more interest than they bargained for.

Frequently Asked Questions (FAQs)

1. How does home equity work?

A borrower acquires a home loan to purchase a property. Investing in real estate is considered a good form of wealth creation. Borrowers make a down payment of 20% (at least) and acquire a loan for the remaining 80%. Borrowers repay this loan in the form of monthly installments.

2. Are home equity loans tax deductible?

Yes, they are tax deductible. As typically stated, the borrower must utilize the funds only to buy, build or substantially improve the property. The entire fund should be spent on the property.

3. Are home equity loans a good idea?

Home loans are a suitable alternative for those wanting to invest in real estate. But the following factors must be kept in mind:
● The down payment should be high.
● Look for minimum interest rates.
● Ensure regular payments—good credit score.

This article has been a guide to What is Home Equity and its meaning. Here, we explain how to calculate home equity, its examples, and its pros & cons. You can learn more about it from the following articles –

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