Understanding Home Equity: Know the Loan and Lender Before You Sign

Home Equity is an important concern to any home owner. You want to not only preserve your home’s equity – you also want to increase it. Sometimes the best way to increase the equity in your home is to make home improvements. It is the old “you’ve got to spend money to make money” routine. However, to do that you might have to tap into the equity in your home via a home equity loan. Obviously this can all become very confusing.

To understand home equity, you must understand what home equity encompasses. Many people erroneously believe that home equity is how much they’ve paid minus taxes and interest; that is, how much they’ve paid toward the principal. That is incorrect. Actually, the equity in your home is based on an even easier to understand formula. The equity is simply how much the home is worth minus how much is still owed on it. So, if your home has a fair market value of $100,000 and you owe $50,000, then you are sitting pretty with $50,000 in home equity. On the other hand, let’s suppose that your property was over valued when you bought it or that, for some reason or other, its fair market value has dropped to $25,000. In that case if you still owed $50,000 you would have zero in home equity despite the fact that you have been paying on this property for some time.

Often a homeowner plans on making some improvements or repairs prior to selling the home or he or she simply wants to make the home a more enjoyable place to live. Unless that homeowner has ready access to cash, that money is usually borrowed. The Home Equity Loan Consumer Protection Act prevents lenders from concealing terms of the loan. Some states have enacted laws which provide the home owner with additional protection. Nevertheless, it would behoove a borrower to always carefully read the loan document before signing.

Usually, when a person takes out a loan based on the equity of their home that is considered what we call a “second mortgage.” The lending institution holding the paper on this loan has rights to your home but their rights are secondary to those of the primary lender. There are several types of these loans.

The first, a Home Equity Loan, is simply an installment loan similar to your mortgage or any other monthly bill you may have. You receive the entire amount agreed upon from the lending institution and you repay it, with interest, in monthly installments. With this kind of loan you are able to use the money borrowed for anything you wish including paying off your other bills

The second type is a Home Improvement Loan. As the name indicates, you can only use this type of loan for home improvements. Sometimes the money is dispersed from the lending institution as the work on your home progresses so that you can pay for the contractors, etc., with the funds on an as needed basis. The funds are then repaid in installments like a Home Equity Loan.

The third type of loan based on a home’s equity is an Equity Line of Credit. This type of loan is rather insidious as it appears to be nothing more than a credit card. Do not be fooled! An equity line of credit is not a credit card. A credit card can be written off, if necessary, as an unsecured debt in a bankruptcy proceeding but anything charged on an Equity Line of Credit, whether those charges be for things like concert tickets or new clothes, is secured by your home. In other words, the lending institution can take your home if you don’t pay.

There is one other kind of equity based loan out there that has been making waves in the past few years. It is called a Reverse Mortgage, and it is completely different than any other kind of equity loan. A Reverse Mortgage is marketed toward the elderly. It provides the senior citizen with funds yet allows them to remain in their home. The concept is that the Mr. Nice Guy Mortgage Company will give the senior citizen all this money and allow him or her to stay in the home so that now the senior has much needed money AND still has a place to live. It sounds too good to be true! Guess what? It is! These lending institutions are snapping up these homes for a song. Yes, the seniors or their heirs can buy back the homes, but the fees associated with that make buying the property back rather prohibitive. Worse yet, because the lending institutions received the property for less than the fair market value, this transaction can, in some circumstances, count as a transfer that can harm the elderly person’s ability to obtain nursing home Medicaid benefits.

Protecting one’s equity is very important. So, when you do decide to bite the bullet and make home improvements, be careful from whom you borrow. When you sign your name on the dotted line you might find you signed up for more than you bargained for.