A home equity loan, or line of credit (HELOC), allows you to borrow money using your home’s equity as collateral.
To begin, let’s make sure we understand these two important definitions:
Collateral is property that you pledge as a guarantee that you will repay a debt. If you don’t repay the debt, the lender can take your collateral and sell it to get its money back. With a home equity loan or line of credit, you pledge your home as collateral. You can lose the home and be forced to move out if you don’t repay what you’ve borrowed.
Equity is the difference between how much the home is worth and how much you owe on the mortgage (or mortgages, if you have a home equity loan or line of credit).
Example: Your home goes UP in value
Let’s say you buy a house for $150,000. You make a down payment of $20,000 and borrow $130,000. The day you buy the house, your equity is the same as the down payment — $20,000. $150,000 (home’s purchase price) minus $130,000 (amount owed) = $20,000 (equity).
Fast-forward five years. You have been making your monthly payments faithfully, and have paid down $13,000 of the mortgage debt, so you now owe $117,000. During the same time, the value of the house has increased. Now it is worth $200,000. Your equity is $83,000: $200,000 (home’s current appraised value) – $117,000 (amount owed) = $83,000 (equity).
Example: Your home goes DOWN in value
In the housing meltdown that affected many parts of the country, homes lost value. Instead of increasing in value, the value of the house dropped after the home was purchased. In many instances, a home equity loan would not be available.
Using the previous example, let’s say you buy a house for $150,000. You make a down payment of $20,000 and borrow $130,000. During the next five years, you paid down $13,000 of your mortgage debt. This leaves you with a balance of $117,000.
However, as home prices fell and homes in your neighborhood went into foreclosure, your home’s value dropped by 30 percent, or $45,000, to $105,000. So now your home is worth $105,000, but you still owe $117,000. Because the value of your home is less than the amount you owe, you have egative equity and would not be eligible for a home equity loan.