A New Age for Home Equity Loans

The bursting of the real estate bubble didn’t just destroy a lot of home equity – it also took a sizeable chunk out of the home equity loan market. However, now that real estate prices have started to recover, expect home equity loans to make a comeback as well.

Still, while the popularity of home equity loans might return, the market will be somewhat different this time. There are some new guidelines you should keep in mind if you are considering a home equity loan.

The Rise and Fall of Home Equity

The real estate boom in the last decade created a great deal of theoretical wealth for American home owners – theoretical, because that wealth was tied to the value of homes most did not intend to sell in the near term. Home equity loans offered a way of tapping into that wealth.

Unfortunately, when the real estate bubble burst, it wiped out much of that equity. According to the Federal Reserve, national real estate prices fell by more than 25 percent from the peak to the bottom, and in some states the declines were in the 40 to 50 percent range. Because any homeowner with a mortgage only owns a portion of property free and clear, these declines in the total price of homes had an even greater percentage impact on the amount of home equity people owned.

More recently though, home prices have started to recover. According to the S&P/Case-Shiller Home Price Indices, as of April, 2013 a composite of 20 major metropolitan markets was up by 13.6 percent since hitting bottom. Most home prices are still below their peak levels, but since most home owners did not buy at the peak, many are already seeing their home equity start to rebuild.

Time also helps. Even if home prices simply stabilize rather than continuing to rise, each monthly mortgage payment adds a portion of principal to home equity. Between the benefits of time and the recovery of housing prices, home equity is on its way back. This sets the stage for a comeback in home equity lending.

Four New Guidelines for Home Equity Loans

That comeback does not mean that it’s 2006 all over again. Lenders are far more cautious, and homeowners should be too. Rising interest rates add another wrinkle to the dynamic. Given the new set of circumstances, here are four new guidelines for home equity loans:

In the last decade, people often used the image of a piggy back to describe home equity as a source of ready wealth homeowners could tap into. Given that homeowners have done a lot of growing up as a result of the housing crisis, it’s time to put away that childish image. Home equity is not a piggy back, but rather the result of a long-term investment. Therefore, any use of home equity should be approached with the seriousness of a long-term investment decision.

  1. Expect to need an equity cushion. The Los Angeles Times found that major lenders were restricting first and second mortgages to a combined 85 percent loan-to-value ratio. So, don’t expect to be able to borrow against your home when you first start to establish equity – you need to build up a cushion of more than 15 percent first.
  2. Keep your credit history shining. Lenders have been burned in two ways: by borrowers who couldn’t meet their loan obligations, and by collateral that could not hold its value. Even as lenders start funding more home equity loans, expect them to be much pickier about who they lend money to. People with spotless credit histories will get easier approval and lower home equity rates.
  3. Don’t put off essential projects. As noted below, there are limits to borrowing against home equity, but if it is for the type of repair that helps to preserve the value of your home, you should not only act, but act quickly. Mortgage rates are rising, which means they will carry home equity rates along with them. So, even though rising home prices may be making home equity loans more available, rising mortgage rates are also making them more expensive.
  4. Don’t borrow for short-term spending. It takes time to build up home equity, and it also takes time to pay off a home equity loan. Therefore, don’t spend that long-term capital and take on a long-term commitment for something that only has short-term value. Using home equity loans for repairs or improvements that add value to your home is the most appropriate use of these loans; using them for things like vacations with no lingering tangible value is the most questionable use of them.

In the last decade, people often used the image of a piggy back to describe home equity as a source of ready wealth homeowners could tap into. Given that homeowners have done a lot of growing up as a result of the housing crisis, it’s time to put away that childish image. Home equity is not a piggy back, but rather the result of a long-term investment. Therefore, any use of home equity should be approached with the seriousness of a long-term investment decision.

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