Nearly four centuries ago, in 1626, Dutchman Peter Minuit managed to buy the island of Manhattan for $24 – which in today’s market is likely to be only enough cash to buy two fine cocktails in an upscale bar in New York City proper.
Yet, statisticians and financial gurus, (from a study several years back) estimate that this paltry sum of $24 would have a current, modern value, in 2014 dollars, of about $1.7 trillion.
That’s trillion with a ‘T.’
In retrospect, in the bright light of hindsight, it is obvious to see time’s impact on the value of real estate. Remember that real estate appreciation – in terms of the passage of time — is a very real, and a tremendously complex phenomenon.
How to Choose a Home Improvement Project
The home improvement project that one decides to take on is a personal decision. For homeowners who have been mulling over a variety of potential home improvement projects, this would be the time to select from that list of projects.
The potential improvements one can make to a piece of real property are only limited by –
- The homeowner’s/designer’s creativity and needs.
- The property’s limitations or land use regulations.
- The local market’s design preferences.
- The local building codes, restrictions, and ordinances.
Remember when choosing to improve your home this completed improvement will –
- Likely impact the home’s future value positively because, as a general rule, real estate (and its improvements & appurtenances) typically appreciate over time.
- Provide your family the opportunity to enjoy these improvements for years.
History has shown that real estate’s inherent and natural appreciation over time eventually creates sufficient equity –
- To help fund the education for the homeowner’s children.
- To help fund the homeowner’s retirement.
- To help fund the vacation of a lifetime.
- To help fund a property upgrade, or any reason a homeowner chooses.
How to Calculate One’s Equity in a Property
To calculate the equity one has in a property is a simple arithmetic calculation. It is as follows –
Current Market Value- Outstanding Property Liens = Available Property Equity
Here is an example – If a home is valued at $300,000 and has an outstanding mortgage of $220,000, the home’s equity would be equal to $80,000. ($300,000 — $220,000).
Most lenders choose not to lend borrowers funds that reach (or near) the property’s total value; however, each lender sets forth their underwriting and lending criteria.
Types of Home Equity Financing
Homeowners generally have two fundamental ways of accessing the equity in their home for additional cash they need. They can apply for –
- A Home Equity Line of Credit, or
- A Home Equity Loan.
Some less restrictive lenders may choose to offer home equity financing options for a second home or investment property, but this is not generally the norm.
Each of these financing options — the HELOC and the home equity loan, provide viable lending options for those borrowers who need capital or cash. What is essential is to recognize is that each of these equity financing tools works differently from each other. Homeowners/borrowers must understand the differences before deciding which of these financial instruments would fit their situation.
What does it mean if my home equity loan/line is a 2nd Position mortgage lien?
The position of a mortgage loan is determined by the date/time it was recorded in the public record. However, there are situations where lien positions can be changed through the use of subordination agreements in the legal process.
But as a general rule, the earliest recorded lien on any given property is recognized as a first position lien. The mortgage used to purchase a home is generally required to be a first position lien because it is the largest lien and typically used to buy the real property.
As such, home equity loans or home equity lines of credit are generally recorded sometime after the first mortgage was obtained.
The reality is the lender is most concerned with the position of any mortgage, but it is noted that a first position lien is always preferred to a second or third or fourth position lien.
From a risk perspective, a second mortgage is considered riskier than a first position lien. This is because when foreclosure occurs for nonpayment, the second position lien is only repaid after any unpaid taxes, and the balance of the first mortgage has been satisfied.
The Home Equity Loan
A Home Equity loan is quite similar to that of a traditional loan that fully amortizes. An example of a fully amortizing loan would be a car loan or boat loan. When a homeowner is approved for a home equity loan, the loan’s proceeds — minus bank fees/expenses — are given to the borrowers as a lump sum. Interest on a home equity loan (which includes the loan’s entire balance) begins accruing the date the loan funds are transferred to the borrower.
A home equity loan is offered as either a fixed or an adjustable-rate mortgage — it depends upon the lender. Should the lender’s underwriter require debt to be paid as a condition of the loan, the closing agent may cut checks from the loan’s proceeds at closing, and then give the balance of the funds to the borrowers.
Like all mortgages (by definition), a home equity loan is a collateralized loan secured by the borrower’s property. The interest paid on a home-secured loan may be deductible as it depends on how the borrowed funds were utilized. The complexity of these tax laws makes it advisable for borrowers/homeowners to contact a tax professional to determine the tax-deductibility of mortgage/home equity loan interest payments.
Fully amortizing loans require borrowers to pay a fixed (equal) installment each month up and through the loan’s last payment date. If a borrower pays equal payments for the agreed-upon schedule, the balance after the last payment will be zero.
While a second mortgage will generally have a higher interest rate than that of a first position mortgage (due to the inherent risk of a second position lien), a home equity loan’s interest rate is typically lower than any interest rate offered for credit cards, personal loans or unsecured loans.
Home equity loans have payback terms between 5 and 30 years; however, most home loans have an average term of 10 or 15 years.
The Pros of Home Equity Loans
The home equity loan offers these following benefits and advantages –
- Lower Rates and, thus, Lower payments — collateralized loans require lower interest rates and offer more attractive terms than non-collateralized loans.
- Large Loan Amounts are Available — home equity loan amounts tend to far exceed limits on personal loans or credit cards.
- Potential Tax Benefits — home equity monies that have been used for home improvement projects are generally tax-deductible — check with your tax expert.
- Flexibility — borrowers have complete control over how the loan funds are used. They can be used to fund college, improve your home, or finance one’s retirement, to name a few options. There are no conditions for the use of the money unless the lender requires any outstanding debt to be paid off as a closing condition.
The Cons of Home Equity Loans
- The Risks –because a home equity loan is secured by your home, this property can be foreclosed upon for nonpayment or loan nonperformance.
- Closing Costs — equity financing tends to have higher closing costs than that of other financial options like a personal loan. However, it is noted that closing costs can be financed by loan proceeds.
- Going Underwater — Choosing to use one’s home equity — and then the home’s value declines, they may owe more than the value of the home. This makes it super challenging (if not nearly impossible) to sell a home without some sort of cooperation from a lender.
The Home Equity Line of Credit (The HELOC)
The Home Equity Line of Credit (HELOC) is another financial instrument that allows homeowners to tap the available equity in a piece of real property. The HELOC more closely behaves like a credit card — or an open line of credit.
A Home Equity Line of Credit provides available credit to homeowners who have the option of borrowing the money (or any portion of the maximum loan thereof), paying it back, and then re-borrowing the funds again. This available preset line of credit is collateralized by the borrower’s real property.
A HELOC mortgage differs from the more traditional home equity loan in that interest on the borrowed funds does not begin to accrue until the borrower uses some (or all) of the available funds sitting in the home equity line of credit. Conversely, the home equity loan begins accruing interest the date the lump sum funds are transferred to the borrower electronically or by paper check.
For this reason, it is possible to obtain a Home Equity Line of Credit and not choose to use the money (available in the line of credit) until after the closing — essentially accruing no interest until the time the funds are used by the borrower(s). Borrowers can only borrow a small portion of the line of credit, which is the balance upon which interest is earned.
In this way, a HELOC’s available line is a great way to earmark emergency funds for any homeowner.
A HELOC — a Home Equity Line of Credit is typically available with interest rates that adjust to market conditions; however, some lenders may offer fixed rates to their best customers.
A Home Equity Line of Credit has a unique structure that performs as follows –
- The Access Period — the period during which funds are accessible and re-accessible. Many HELOC lending institutions give borrowers the option to pay interest-only during the access period. A typical access period runs ten years.
- The Repayment Period — the period during which the home equity line of credit is closed, and no additional borrowing is allowed. The borrower is then provided a predetermined timeframe (generally between 5 and 20 years) to repay the outstanding balance in equal monthly installments.
Those lines of credit that only require interest-only payments during the access or repayment period will likely have a large lump sum — a balloon payment – at the end of the loan’s term.
Be certain to have a full understanding as to the terms of the HELOC or home equity loan BEFORE executing the promissory note and mortgage doc at closing.
The Pros — HELOCs — the Home Equity Lines of Credit (HELOCs)
The advantages of a home equity loan are as follows –
- HELOCs typically offer lower interest rates than credit cards or unsecured loans.
- HELOCs typically offer larger credit lines than credit cards or unsecured loans. HELOCs can exceed $1 million dollars, or more, depending on available equity and the borrower’s creditworthiness.
- HELOCs may have Tax Benefits – HELOCs that are applied and used to improve one’s home are generally considered tax-deductible; however, borrowers are encouraged to check with a tax expert.
- Flexibility – HELOC funds can be used for many objectives and can be reused when paid back.
- Interest accrues on the outstanding balance only of the used HELOC funds – interest does not accrue on the unused portion of the home equity line of credit.
The Cons – HELOCs – the Home Equity Lines of Credit (HELOCs)
- Risk – HELOCs are collateralized by real property, which can be taken in a foreclosure action for nonpayment.
- Rate Risk – interest rates for HELOCs are generally adjusted in response to market conditions. As such, the number of minimum payments can change when and if interest rates adjust.
- Closing Costs – equity/collateralized financing cost more to close than the cost to close a personal or unsecured loan. However, for those short on cash, the amount it costs to close a HELOC can be funded through the line of credit’s proceeds.