Home Equity: If You Use It, You Lose It

Home equity is a powerful financial tool, as well as a resource that's difficult to replace.

In this election year, you might hear environmentally-friendly politicians arguing over the use of non-renewable resources. Of course they're talking about coal and natural gas, but maybe home equity should become a part of that discussion.

Home equity basics

Home equity is the difference between your home's market value and the amount of outstanding mortgage debt that you owe. If your home appraises at $450,000, for example, and you owe $200,000 in mortgage debt, the value of your home equity is $250,000.

This $250,000 is an asset that can be used to secure additional borrowing. If you need to borrow money for a home remodel, your kid's college tuition, or a new car, you can do so on the strength of your home equity. You can't borrow the entire $250,000, but you can generally borrow 70 to 75 percent of your home's value. In our example, that equates to $315,000 to 337,500.

Accounting for the $200,000 of first mortgage debt, we arrive at home equity borrowing power of $115,000 to 137,500.

If you're wondering why you can't borrow against your entire equity, just consider the prospect of property value declines. Lenders don't want to be stuck holding collateral that's worth less than the amount of debt taken out against it. Therefore, the lender must leave that cushion of 25 to 30 percent between the home's value and the allowable debt amount.

Downside of home equity

Returning to our example, an influx of more than $100,000 of cash to a household can be cause for celebration. But it doesn't come without a downside. Once you fund that home equity loan, you reduce your borrowing power to zero. And you can't replenish that borrowing power until your home's value goes up, or your debt goes down. In today's economy, both of these can take a considerable amount of time.

If you aren't confused enough, there's one more factor to consider. Sometimes, it's hardest to obtain a home equity loan when you need it most. If you suffer a loss of income, for example, mortgage lenders aren't going to provide the credit that you need to get through those rough times. For this reason, some homeowners open a home equity line of credit (HELOC) while they're still gainfully employed. HELOCs are appropriate for this purpose because they allow you to borrow in increments as needed.

In summary, home equity is a lot easier to use up than it is to replace. This means that you should have a very good reason for flexing that home equity borrowing power. Just so you know, conventional wisdom says that an exotic vacation and flashy jewelry don't qualify as good reasons. The best strategy is to treat that home equity as a precious, non-renewable resource; that way, it'll be there for you when you need it most.

Home Equity Loan Tips By: Catherine Brock