Home Equity

Now that we understand how it is that the costs of mortgages are applied, let’s go into a bit more detail about how the value of a mortgage is assessed. Specifically, we need to know about Home Equity, so that we can understand what sort of value we’re bringing to the bargaining table.

Home equity is a figure that represents how much money your home is worth. As the value of your house increases or decreases, the value of your home equity changes accordingly. Realistically, this value represents the how profitable an investment your home has proven to be. If the rate at which your home increases in value exceeds the interest rate of your loan, your home is a fully profitable investment, which has effectively paid for itself.

If your home equity value increases at a rate than less than your interest rate, but continues to do so after you have paid for your home, it is also a profitable investment, but with a longer time horizon. However, if your home decreases in value, you’ll run into some pretty serious problems.

A mortgage is given to a borrower in accordance to the value of the home’s equity. If a home is valued at $100, 000 at the time of the loan, a customer will generally be loaned $100,000. However, if the value of the home decreases to $80,000 after the loan is given, the borrower will still owe the bank funds as if it were still worth $100,000.

Worse yet, in some situations, the bank may actually require that the borrower post additional collateral worth the $20,000 difference, because the home is no longer worth enough to cover the value of the loan. If the borrower cannot procure the collateral fast enough, they will very likely see their home foreclosed, because the bank does not feel as though it is capable of taking on that level of risk.

The way in which a borrower is best able to protect themselves from the risk of temporary fluctuations in home equity value is through a down payment. By paying between 5-20% for the home upfront, the borrower has a cushion against the risk of home depreciation. What’s more, banks usually recognize that these down-payments save them from the hassle of having to re-possess a house, and so they will generally reward the borrower with a lower interest rate, based on how much of a down-payment was made.

Since a down-payment also represents a financial commitment to the home upfront, it also means that the borrower is less likely to default on the loan, because they have a greater vested interest in the home.

The lesson to learn here is that a down-payment is definitely worth the trouble, because it will save you a great deal of trouble down the road, should economic fluctuations begin to have an impact on the value of your home.

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