There is always a danger when discussing home equity loans to do so in an isolated environment that does not take into account other market factors. Among those other factors are housing prices. The price paid by the average home buyer in any given geographic region has a very definite impact on how home equity loans are packaged and offered by lenders. It also affects the consumer's financial position once a loan has been obtained.
To help make this more understandable, we have divided the topic into two parts: how housing prices affect lenders and how they affect borrowers. Understanding the dynamic relationship between housing prices and home equity lending should provide a clear picture of when it is appropriate to borrow.
Housing Prices and Home Equity Lenders
Home equity loans are offered on the basis of property owners using the equity in their homes as collateral. That much is well understood. What some property owners struggle with is the concept of loan-to-value ratio. Also known more simply as LTV, this ratio represents the percentage of equity a bank is willing to lend. A 50% LTV on equity of Â£100,000 would enable a borrower to get a Â£50,000 loan.
The challenge for lenders is to balance the risk of lending against projected housing prices in order to set an attractive LTV. As housing prices fall, so does equity. This is why the last housing crash resulted in millions of property owners finding themselves in a negative equity position. Prices fell so far that homeowners end up owing more on their mortgages than their homes were worth. The negative equity scenario presents a greater risk for lenders where home equity loans are concerned.
Let's say a lender offers a Â£50,000 loan with a five-year term. That loan is offered with the understanding that the borrower's property value will remain relatively stable or grow over the term. But what happens if housing prices fall one year into the loan term? Equity will fall with it. This increases the lender's risk by making the property worth less in the event it has to be sold to make up for loan default. Greater risk translates into higher interest rates and less favourable terms for borrowers.
Housing Prices and Home-Equity Borrowers
If you understand how housing prices affect the lender, you should have a pretty good idea of how they affect the borrower as well. Imagine being in a position of approaching negative equity because housing prices fall too far, too quickly. Now imagine being in that same situation and having an additional Â£50,000 in home-equity debt hanging over your head.
Any negative equity situation is obviously made worse when a homeowner also has a home equity loan attached to his or her property. Any chance of a significant fall in housing prices should be enough motivation for property owners to be cautious about borrowing â?? at least until the risk subsides.
In cases where homeowners are already paying on home equity loans when house prices fall, there is not much that can be done to change things. In some cases, a negative equity position may not be preventable. The best a homeowner can do is to work hard to make sure payments are made on time so as not to default on the loan.
Keep in mind that selling a home to make good on loan default does not necessarily absolve the borrower of all financial responsibility. If the property sale does not generate enough cash to repay the total amount owed, the borrower is still legally obligated to make up the difference.
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