Understanding the Role of Equity in Refinancing Your Mortgage
by Ellise Walsh

Equity can be a tremendously important factor in refinancing your mortgage, especially if you are looking at re-mortgaging your home in order to raise some much needed cash. First, let’s take a look at what equity is and how you build it into your home.

Positive equity is the amount of money your home is worth above and beyond the payoff balance on your mortgage loan. Because market values shift, dependent upon a variety of factors, it is entirely possible for your home to be worth significantly more than the amount of money you owe on your mortgage. One of the primary ways this occurs is when property values increase. This generally occurs as a natural course of events, without much effort on the part of the homeowner. If there has been an increased demand for the type, style or location of your home, your property value can increase almost overnight, raising your equity as well.

Another manner in which a homeowner may see a rise in their property value is when they make home improvements. The addition of luxury features, security systems and landscaping can raise the value of the property, further increasing the equity.

Finally, homeowners build equity into their home with each and every mortgage payment they make. This occurs at an almost infinitesimal rate with most mortgage loans during the first payments because more money is going towards interest than principle. Gradually, however; the balance on the loan begins to decrease and, provided nothing occurs to devalue the property, the homeowner begins to build up equity into the property.

It is possible, although much less likely, to have negative equity in a home. This situation occurs when the property is valued at an amount less than the amount owed on the mortgage. If there has been deterioration in the neighborhood, property values may decline. Neglect of the home, resulting in cosmetic or structural damage, will also result in a declining property value and subsequently in negative equity. Natural disasters that damage the home and property can also lead to reduced property value and negative equity.

If you are considering refinancing your home for the purpose of accessing cash through your home’s equity, you should be aware of how this process works. Basically, it allows you to obtain another loan for your home, based on the home’s current value. The first mortgage loan is paid off with the proceeds from the new mortgage loan and the homeowner is typically able to take the remaining funds (minus any fees) in order to finance other purchases or consolidate debts. The new mortgage loan will be for the amount of the old loan plus whatever equity the homeowner took in cash. In the event the homeowner defaults on the second loan, the effect will the same as if they had defaulted on the first loan; they will lose their home.

Besides the fact that you are putting your home up as collateral for the new loan, you are also reducing your ability to tap into your home’s equity again in the future--at least for awhile.

Individuals choose to access the equity they have built up into their home for a variety of reasons but the most common reasons typically include: purchasing a vehicle, going on holiday, funding education costs, paying for medical treatments, financing major purchases, funding a business start-up or other kind of investment, debt consolidation and home improvements. Of all the reasons to access equity for extra money, the reason that is perhaps the easiest to justify among homeowners, is accessing cash for the purpose of funding home improvements. Many homeowners justify raising the cash for this purpose because the money is being re-invested back into the home and property, which will hopefully further raise the property value.

Although many homeowners do choose to access their home’s equity for varied reasons, finance experts recommend that it isn’t wise to use your equity to pay for trips and major expenses that you could just wait and save to fund. Additionally, finance gurus state it’s unwise to put your equity towards paying for living expenses. Instead, you should look into financial counseling to find a better way to solve your money problems. Finally, while there can be advantages to consolidating debts with the cash you receive from accessing your equity, you should always consider how you will avoid similar problems in the future after you’ve exhausted your home’s equity as a solution.

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