Miranda Marquit

Equity, where finances
are concerned, most often deals with homeownership. Essentially, equity
represents your ownership in a home that you purchase with a mortgage.

How Equity Works

Since most people
can’t afford to buy a home outright with cash, they need to turn to a lender
for a loan. Once the borrower is accepted, the lender provides the loan for the
house, called a mortgage. The homebuyer then repays the lender over time.

As long as the
homebuyer owes the lender money on the mortgage, the lender can repossess the
home. Over time, as the buyer makes payments on the mortgage, he or she starts
to build equity – or ownership – in the home. 

Another way to express
equity is as the difference between what your home is worth, and what you still
owe on the mortgage. As your home increases in value, you see more equity. If
your home is worth $200,000, and you still owe $130,000 on your mortgage, the
equity in your home is $200,000 - $130,000, or $70,000.

Equity is expressed as
a percentage in many cases. In the example above, you have $70,000 equity in
your home, which is 35% of $200,000. Over time, you can eventually build up
enough equity to completely own your home, meaning you have 100% equity, and
the bank no longer has claim to ownership in your house.

The flip side is that
you can also have negative equity in your home. This is when you owe more than
your home is worth. This can happen if home values drop. If you owe $180,000 on
your home, but it has dropped in value to $160,000, you have $20,000 in negative
equity.

Using the Equity in
Your Home

As you build up
ownership in your home, you can use your equity as collateral for financing. If
you have $70,000 equity in your home, you might be able to borrow $40,000
against that ownership. You can make home improvements, pay off debt, or do
something else with the money. If you miss payments, though, the lender can
repossess your house, because now the home equity lender has ownership in your
home, and your own equity has been reduced to $30,000, or 15% (using the
$200,000 example above).

Equity is most
important when you sell your home. After you sell your home and pay off your
mortgage, whatever money you have left will be equal to the equity you had in
the house. If you’ve managed to build up a large amount of equity during the
time you owned the home, then you’ll have a large amount of money ready to use
as your next down payment or to simply keep for yourself.

Generally, when you buy a home, you are expected to make a down payment. Your down payment reduces the amount that you borrow, and helps you start out with equity in your home. However, in some cases it is difficult to come up with the money you need for a down payment. The good news is that, in some cases, it’s possible to get help from your lender.

80/20 Loans

Prior to the financial crisis 2008, one of the common types of down payment loans was the 80/20 loan. Basically, the lender gives you a loan of 20% of the purchase price, and that serves as the “down payment.” The remaining 80% is then borrowed as well. The smaller loan, though, has a higher interest rate attached to it.

The main advantage to the 80/20 loan is that it provides you with a way to avoid Private Mortgage Insurance, since you are technically putting a 20% down payment on your home. It’s possible to find lenders that offer 80/20 loans, but they are less prevalent in the past.

FHA Down Payment Loan

You can also receive a loan to help meet your down payment requirement for a FHA loan. While the down payment is smaller with a FHA loan, you will still have to pay the FHA insurance if you don’t have a large enough down payment.

Friends and Family Down Payment Loan

While a lender can provide you with a down payment loan, a friend or relative usually cannot. Most lenders will not want you to use a loan from another source as your down payment. With a mortgage loan, it’s possible for you to accept a true gift from a relative for your down payment, but you can’t plan to pay it back. Many lenders require you and the donor to sign paperwork affirming that the money is the true gift.

One of the ways that you can get the best deal on your mortgage is to use a mortgage broker – a financial who works to match borrowers up with lenders.

What is a mortgage broker?

Rather than limiting you to one type of loan with one lender, as a regular loan officer might do, a mortgage broker can leverage a wide network of banks in order to give you access to a variety of different loan options. Mortgage brokers can help you determine your eligibility for FHA loans, VA loans, first-time homebuyer programs, sweat equity programs, and other options that you might not be aware of.

What does a mortgage broker do?

The main role of a mortgage broker is to give buyers more choices as they look for mortgage rates to purchase a home. Unlike a loan officer, a mortgage broker isn’t associated one particular bank. This means that the mortgage broker can collect offers from a number of banks, offering you different deals. Brokers can also reduce the required paperwork by filing certain parts of the application on behalf of the borrower. 

Why use a mortgage broker?

A mortgage broker works as a middleman between the buyer and the bank. Instead of going into different banks to find out if you qualify for a home loan your mortgage broker will take care of all communication between you and the banks. Those with poor credit, or self-employed individuals who cannot prove their income, often benefit from the network and assistance of a mortgage broker.

You do need to be careful, though. Mortgage brokers are paid by banks, and so represent their interests. Additionally, a Congressional investigation found that home buyers who acquired their mortgage through a broker paid up to $400 more on average during closing costs than did those who dealt directly with a lender. 

Mortgage brokers are also rewarded a yield-spread premium for having a borrower agree to pay a higher interest rate for a loan. While many mortgage brokers are honest and work hard to get their borrowers the best deal, there are others who prey on less knowledgeable consumers, jacking up their interest rates, and pocketing extra commissions. As a borrower you should always protect yourself by conducting research outside the broker’s office.

Homebuyers are not limited to working with a single mortgage broker. Just like you would shop for a loan, you should shop for a broker, since different brokers have access to different lenders. By speaking with a few more brokers, you might dramatically expand your mortgage options.

When you begin considering your mortgage options, one of the loans you might run into is the 5/1 ARM. This is a loan that starts out with a five-year fixed rate, and then switches to a variable rate, which changes once a year during the remaining years of the loan. That is what the 5/1 means: The loan is fixed for the first five years, and each year after that, the interest rate adjusts. The fact that the interest rate (and your monthly payment) only changes periodically therefore gives a 5/1 ARM a level of stability relative to other ARMs, which have rates that may change on a monthly or semiannual basis.

The 5/1 ARM can be an attractive mortgage option because it often starts with a fairly low interest rate. The introductory interest rate is usually lower than what you would see with a fixed rate loan – sometimes by as much as a full percentage point. However, you should be prepared for the fact that when the five-year fixed-rate period ends, your interest rate, and your monthly payment, could rise. Most ARMs come with a cap. This cap can either be a periodic cap, which limits the amount that the rate can rise each interest period (often quarterly or annually), or a lifetime cap, which limits the total increase for the interest rate over the lifetime of the loan.

Many homeowners start with a 5/1 ARM intending to refinance to a fixed-rate loan before the initial period expires. Freddie Mac reports that the average pay off period for mortgage loans is a little less than four years. This means that many owners either sell or refinance (or foreclose) within this time period. Even during 2008 and 2009 when that average bumped up, it still remained less than five years. To be able to refinance you will need to have a certain amount of equity in your home; if refinancing is your plan, you should figure out the loan you want to eventually take and make sure you will qualify for it under your current schedule.

Your home equity line of credit can present a serious strain on your budget – especially if you are already in trouble. Many people wonder if it’s possible to discharge a HELOC during bankruptcy in order to avoid continued payments. Whether or not you can discharge the HELOC, though, depends a great deal on the type of bankruptcy you choose.

Chapter 7 Bankruptcy

The short answer as to whether you can discharge a HELOC during Chapter 7 bankruptcy is “no.” At least not if you want to keep your house. During Chapter 7, you liquidate your unsecured assets, and your creditors are paid with whatever funds derive from the sale. This means that they may not get paid in full, but your situation is deemed severe enough that you aren’t required to pay all that you owe. However, if you want to keep your house, you have to keep making the HELOC payments. As long as you are up to date, you can usually keep your home.

Chapter 13 Bankruptcy

You can actually use Chapter 13 bankruptcy to get rid of a HELOC. With Chapter 13 bankruptcy, you create a payment plan that lasts three to five years. During this time, you continue paying on your first mortgage. The rest of your disposable income goes to a trustee assigned by the court. The trustee can then distribute payments to your creditors – including the HELOC lender.

Once the period of bankruptcy is over, your HELOC, along with credit card balances, are discharged/eliminated. As long as you continue paying your first mortgage you should be able to keep your house.

Each case is different, though, and the terms of your bankruptcy will vary. The bottom line is that if you are interested in eliminating your HELOC and keeping your home, Chapter 13 is your best bet. Chapter 7 bankruptcy won’t allow you to discharge your HELOC while keeping your house.

As always, though, you will want to consult a bankruptcy attorney to learn your options, and have the possibilities fully explained to you.

There are many reasons that people get home equity loans. Home equity loans can be used for home improvements, debt consolidation, college tuition, a child’s wedding, or for other purposes. However, after a while a homeowner might want to refinance to better terms. The good news is that, in most cases, it’s possible to refinance a home equity loan – as long as you have the required equity in your home.

If the amount owed on all your home loans and lines of credit is more than your home is worth, you probably won’t be able to refinance a home equity loan. Most lenders prefer that you have a loan-to-value ratio of 80% or less in order to refinance. While there are programs which can help you avoid that requirement for your first mortgage, refinancing a home equity loan when you have little equity in your home is difficult.

If you are looking to refinance a home equity loan, consider the following good reasons to do so:

·     Pay a lower interest rate: If you are unhappy with your current interest rate, consider refinancing your home equity loan so that you have a lower rate. The potential savings for a lower interest rate run in the hundreds of dollars.

·     Lock in a fixed rate: Many home equity loans and lines of credit come with variable rates. If you are concerned that interest rates will rise soon, lock in a lower fixed rate now to keep your payments predictable.

·     Reduce your loan term: A home equity loan often has a 30-year term. If you want to build equity faster, a shorter-term loan can help. Refinance your 30-year home equity loan to a 20-year or 15-year term, and you could see overall savings while boosting the ownership you have in your home.

Remember, though, that there are some risks associated with home equity loans. If you are required to pay fees, it will take longer to see the benefits of refinancing. A lower monthly payment looks attractive, but you might not actually save any money in the long term if the terms of the loan aren’t favorable to you. Make sure you carefully consider these expenses before refinancing your home equity loan.

If you are looking for a lower interest rate, but also want a fixed-rate period, you can consider a hybrid loan. These loans start out as fixed-rate mortgages for a limited period of time, and then switch to a variable rate loans after the initial period ends. There are two main types of hybrid loans:

1.  Hybrid fixed/adjustable rate loans: These loans are considered hybrids because, instead of just offering a fixed rate or an adjustable rate, you start out with a fixed rate, but the loan re-sets to an adjustable rate later. The initial interest rate is often low, and sometimes called a “teaser.” Your low fixed rate can last anywhere from one year to 10 years. Once the original period is over, you start paying an adjustable rate.
   
2. Hybrid Option ARMs: The hybrid option ARM has a fixed-rate period, and an adjustable-rate period, as well. However, the “option” is manifest by the way the borrower chooses the amortization schedule for a portion of the loan term. The borrower can choose to pay only the interest on the loan for part of the loan, and even choose to pay less than the interest owed. It’s also possible to choose a payment in line with a 15-year or 30-year amortization schedule.
   

In certain circumstances, hybrid loans can provide advantages for borrowers. For those who want to take advantage of low interest rates, a “regular” hybrid fixed/adjustable rate loan can be helpful. However, it’s important to make sure that you can handle the adjustable payments after the re-set, or refinance to a fixed rate before interest rates rise.

Option ARMs are even riskier when used irresponsibly. While the ability to change payments month to month can be helpful in some cases of irregular cash flow, the fact of the matter is that hybrid option ARMs can be devastating as well. If you don’t make bigger payments on months when you have a higher income, you can add to your principal in months when you choose the negative amortization option. If home values drop, you can’t refinance, and you quickly end up under water.

Hybrid loans should be approached carefully; they are not often the best choice for those who are stretching to afford a home.

One of the ways that the government, since 1913, has encouraged home ownership is with the help of the mortgage interest tax deduction. This is an itemized deduction listed on Schedule A of your Form 1040. Beginning with homes bought or built after October 13, 1987, there are limits to how much you can deduct, as well as a phase out of the deduction.

Right now, you can only deduct your mortgage interest on debt up $1 million (total) on first and second homes for those who are married filing jointly. For those married filing separately and those filing single, the limit is $500,000. It’s also possible to deduct the interest on home equity loans of up to $100,000 ($50,000 for those not filing jointly).

On top of the debt limits associated with the mortgage interest tax deduction, there is also a phase out.   If you have an adjusted gross income of more than $166,800, your deduction will begin to phase out. For every $100 of income you have above the threshold, you lose $3 (or 3%) of your itemized deduction, multiplied by 33.3%. The maximum loss is 80% of your itemized deductions. If you make $266,800 a year, and pay $15,000 in mortgage interest, you are $100,000 over the threshold and your deduction will be reduced by $3,000 x 33.3%, or $999. Instead of deducting $15,000, you only deduct $14,001.

It’s important to note that there have been various proposals in the past to change the mortgage deduction. Indeed, the formula for figuring the deduction phase out has already been tinkered with in the past. Some suggestions include getting rid of the deduction for those above a certain income (such as $250,000), or eliminating the deduction altogether. While the issue is regularly debated by politicians, a USA Today and Gallup poll published in April 2011 indicates that 61% of Americans are against getting rid of the mortgage interest deduction – even though the Treasury Department believes it could save the government close to $100 billion in 2012.

When you buy a home with the help of a mortgage, there is a good chance that you will need to purchase mortgage insurance. Realize, though, that private mortgage insurance (PMI) is designed to protect a lender in case a borrower defaults on their payments. PMI mortgage insurance is designed for those who borrow more than 80% of the home price (less than 20% down).

When you borrow, the lender will use a formula to determine how much you will pay. Normally, the calculation is based on the length of mortgage that you have, as well as how much, in terms of loan-to-value ratio, you are borrowing. A normal range for mortgage insurance is a rate somewhere between 0.30% and 0.80% of the total borrowed.

The more you put down for a payment, the lower your PMI mortgage insurance rate will be. For example, someone who is borrowing 85% of the home’s price might pay a mortgage insurance rate of .32%, while someone borrowing 95% of the home’s value might pay .78%.

To figure out how much in private mortgage insurance you will pay each year, you can multiply your rate by how much your loan is for. If you are buying a home for $200,000, and you put 5% down, your LTV will be 95% (you are borrowing 95% of the home’s price. Your down payment would be $10,000 and your loan would be for $190,000. Multiply that $190,000 by .0078, and you will see that your yearly mortgage insurance payment is $1,497.60. Divide that number by 12, and you see a monthly payment of $124.80.

It’s worth noting that once your loan-to-value ratio drops below 80%, you no longer have to pay mortgage insurance. When you reach 78% loan-to-value ratio, the lender is required cancel your PMI automatically.  Pay attention to your balance to avoid paying private mortgage insurance unnecessarily.