The practice of borrowing against the value of a home has skyrocketed in popularity. There are two key reasons for this surge: low interest rates and tax deductibility. When tax changes in 1986 eliminated deductions for most consumer purchases, home equity loans became a way to buy goods and still get a deduction.
Let's say you bought your home for $95,000 and made a 20 percent down payment of $19,000. You then took a first mortgage to pay the remaining $76,000. On the day you closed on your home, you automatically had 20 percent equity. You gain equity as you pay off the principal and your home grows in value.
Let's say you've paid $12,000 toward the principal and your property -- valued at $95,000 when you bought it -- is now worth $115,000. Your beginning equity ($19,000), plus the principal you have paid ($12,000) and the increase in your property value ($20,000) gives you $51,000 in equity.
Banks and borrowers love it.
Equity is a valuable asset because you can put it to use without having to sell your home. And because most people's domicile is their biggest asset, lenders regard home equity loans as secure. For that reason, interest rates are lower than for other loans. The average rates for a home equity line of credit or for a term equity loan are available from Bankrate.com's current survey of 4,000 banks around the country.
Home equity products usually have a higher interest rate than first mortgages. (Bankrate.com's mortgage rate survey will show you those differences.) But compare home equity loan costs to your credit card or department store charge cards. Check out Bankrate.com's current credit card rate survey, then figure in a tax deduction on your home equity loan, in most cases for up to $100,000 of borrowed money, and you've got yourself a deal.
The scary part is that if you default on the loan, the lender could foreclose on your home. That's why these loans are statistically most suited to stable, middle-aged borrowers. The average home equity customer is 35 to 49 years old with a household income of $63,000, according to the Consumer Bankers Association. Fifty- to 65-year-olds are the second biggest borrowers of home equity.
Most have held the same job and owned their home for about eight years. Less than 2 pecent default on their loans. "Home equity customers tend to be very good at paying back their loans," says Bill Hampel, chief economist for the Credit Union National Association in Washington, D.C.
Credit Basics. You've Heard of Credit Scoring, But What Exactly Is It?
Credit scoring is a scientific method that uses statistical models to assess an individual's credit worthiness based on his or her credit history and current credit accounts. Credit scoring was first developed in the 1950s, but has come into increasing use in the last two decades.
In the early 1980s the three major credit bureaus, Experian, Equifax and Trans Union all worked with the Fair, Isaac company to develop generic scoring models that allow each bureau to offer a score based solely on the contents of the credit bureau's data about an individual. Creditors especially those in the mortgage industry frequently use the scores when deciding who receives loans. They can order your score, commonly called a FICO score, from one of the bureaus, but it only draws upon information from your credit report. Individual creditors often also consider other information, such as your salary or how long you have been employed at the same company when making loan decisions.
Now you can see the type of score lenders use when deciding whether to give you that loan. Along with your Personal Credit Score, you’ll receive personalized analysis and tips that can help you improve your credit rating. So know the score today!
What Does It Mean?
Each credit bureau has its own unique system for compiling credit scores. However, the scoring models have been normalized so a numerical score at one bureau is the equivalent of the same numerical score at another. Thus, a score of 700 from Equifax indicates the same creditworthiness as a score of 700 from Trans Union or Experian, even though the calculations used to determine those scores are different at each bureau.
A computer-generated score is compiled using information from an individual's credit report, such as how much money is owed and whether payments have been made on time. Then that score is compared to the credit performance of consumers with similar profiles. The scoring system awards points for each factor that helps predict who is most likely to repay a debt. A total number of points-a credit score--helps predict how likely it is that you will repay a loan and make payments on time.
Credit scores range from 375 to 900 points, but those numbers mean little on their own. They become meaningful and useful within the context of a particular lender's own cutoff points and underwriting guidelines.
What’s A Good Score?
In general, you are likely to be considered a better credit risk if your FICO score is high. Under mortgage lending guidelines, for example, a score of 650 or above indicates a very good credit history. People with these scores will usually find obtaining credit quick and easy, and will have a good chance to get it on favorable terms.
Scores between 620 and 650 (average FICO scores fall into this range) indicate basically good credit, but also suggest to lenders that they should look at the potential borrower to assess any particular credit risks before extending a large loan or high credit limit. People with scores in this range have a good chance at obtaining credit at a good rate, but may have to provide additional documentation and explanations to the lender before a large loan is approved. This means that their loan closing may take longer, making their experience more like that of borrowers in the days before credit scoring, when every individual was researched.
A score below 620 may prevent a borrower from getting the best interest rates, as they may be considered a greater credit risk-but it does not mean that they can't get credit. The process will probably be lengthier and, as noted, the terms may be less appealing, but often credit can still be obtained.
Mortgages: How mortgages work.
A mortgage is basically a long-term loan that you arrange through a bank or other financial institution, or even through the seller of the property. The house and/or property serve as collateral for the loan.
A home mortgage is most likely the largest debt you will assume. You typically pay off that debt in monthly payments over a long period of time, most often 15 to 30 years.
What's in a payment? A monthly mortgage payment typically includes the following, known as PITI:
• Real estate Taxes,
• Property Insurance and, often, private mortgage insurance, known as PMI.
PMI gives the lender protection if the homeowner should default on the loan. The mortgage company charges insurance if the down payment is less than 20 percent of the sale price or appraised value. PMI usually can be eliminated once the principal balance of the mortgage reaches 80 percent of the sale price or appraised value, which is known as the loan-to-value (LTV) ratio.
The process of paying the principal takes years because mortgages are based on a repayment plan called amortization. During the years of the mortgage, a homeowner pays a lot of money toward interest in order to have manageable monthly payments on the huge house debt. During the first few years, most of the mortgage payments will be applied toward the interest. During the final years of the loan, the payments will be applied primarily to the remaining principal.
Let’s look at a $100,000 mortgage, at a fixed interest rate of 7.5 percent, for 30 years. In three decades, the homeowner would pay $151,717 in interest.
Of course, you cannot put a price on the pleasure of living in your own home and building equity, an unencumbered interest in your property. Equity grows as you pay off the principal of the mortgage and as the property appreciates in value. Also, there are tax incentives, since mortgage interest is a deduction on your federal income tax.
Still, the amount of interest you will pay may affect your decision on what type of mortgage you choose.
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