Home equity loans Simple example of borrowing from equity to fuel consumption
Home equity loans
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- Welcome back.
- In the previous video we had this very positive scenario,
- where I had originally bought a house for $1.5 million.
- Then a year later, the value of the house, or at least my
- perceived value of the house, went up to $1.5 million,
- because my neighbors sold their identical
- house for $1.5 million.
- And so my initial equity investment went from $250,000
- to $750,000.
- And why is that?
- Well equity is nothing but, if I have an asset that's worth
- $1.5 million, and I owe $750,000-- that was my
- original mortgage on that asset-- then what I'm left
- with is the equity.
- So my equity just tripled.
- It went from $250,000 to $750,000.
- In this video, what I'm going to do is I'm going to show
- you, well, what can you do with that equity?
- I mean, it's not cash.
- It's kind of like this make believe amount of wealth that
- you have. You just feel richer.
- And I'll show you that you can actually turn it into cash
- using something called a home equity loan.
- And I'd argue that this is actually what drove our
- economy from about 2002 to probably still, to this day.
- Although I think we're in a recession now.
- In fact I'm about 100% sure we are.
- But definitely until about 2006.
- So what's a home equity loan?
- Well I go to the bank.
- I say, wow, bank, I have this $750,000 of equity.
- I wish -- I'm rich, but I don't have this in cash.
- I want to do something, though, with the equity.
- I would like to live like a rich person.
- Well the bank says, Sal, you know, you're right.
- Our only requirement is that you have $250,000-- or our
- only requirement is that you have 25% equity
- in your house, right?
- Because they want a cushion in case you can't pay and they
- get the house back, and they have to foreclose, and auction
- off the house, et cetera, et cetera.
- So they said, well, we're willing to lend you up to 75%
- of the value of your house.
- So what's 75% of the value of my house?
- So let's see, 1.5 times 75%, let's see that would be
- $750,000 plus half of $750,000.
- It'll be 1.075 million, I think.
- I did that in my head, it could be wrong.
- But it's roughly the right number.
- So the bank says, you know what, we're willing to lend
- you up to 75% of the value of your asset.
- And it's of course going to be guaranteed by this asset.
- So far, we lent you $750,000.
- So let's see how much you have more that you
- can borrow from us.
- Minus -- we're talking millions -- that's 0.075.
- So that's what?
- 300, that's 250 plus 75, so up to $325,000 more that you
- could borrow.
- And what is this?
- Where am I taking this money out of?
- Well I'm essentially taking this money out of the equity
- of my house.
- And how does that make sense?
- Well, what's going to happen?
- Let's say I take this loan.
- Let's say I say, bank, great.
- I want $325,000 in cash.
- I want it right now.
- So what happens?
- Let me draw another series, another balance sheet.
- I stopped using the word balance sheet, even though
- that was the original purpose of this whole discussion.
- I'll draw it a little bit bigger.
- Remember liabilities plus equities are equal to assets.
- So what are my assets now?
- So now I have a $1.5 million house, and I also got $325,000
- cash from the bank, so we can call that 325K cash.
- Got it from the bank.
- Now what are my liabilities?
- Well I have the original mortgage on my house.
- The original mortgage is $750,000.
- This is liabilities on this side.
- Well not the whole side, we're going to
- have equity down here.
- So just this is liability, $750,000.
- And then I took a new loan to get this $325,000 of cash.
- So I have a new loan here, that amount is $325,000.
- And this was a home equity loan.
- I took a loan against the equity that
- I have in my house.
- This was the equity in my house.
- So what's the leftover equity?
- Let me just make everything clear.
- These are liabilities.
- These are assets.
- And equity is what you have leftover.
- So what are my assets?
- I have $1.825 million in assets, minus -- now what are
- my liabilities?
- Minus $1.075 -- that was the max that I could borrow --
- Assets minus liabilities is owners equity.
- So let's see, 825 minus 75.
- I still have $750,000 of equity.
- And that makes sense.
- If I just enter into some transaction where I get cash
- in exchange for debt, my equity shouldn't change.
- But now what does happen?
- Well I have this cash, and I'm feeling rich, because I've
- never seen numbers like $750,000.
- And that neighbor, that new neighbor that just bought that
- house right next door for $1.5 million, he just bought a
- beautiful new Hummer.
- And being a very down-to-earth person, I feel that I also
- deserve a Hummer, like my neighbor, because I am just as
- rich as they are.
- So I go decide to go out and I'm going to spend
- $100,000 on a Hummer.
- Actually, let's not do a Hummer, because a Hummer could
- actually be considered an asset.
- I want pure consumption.
- Although I think a Hummer is as pretty close as a car gets
- to pure consumption.
- Let's say that neighbor went on a round-the-world vacation
- for $100,000.
- And I too, because I did nothing but sit on my house
- and made $500,000 last year, I feel that I also deserve a
- $100,000 vacation.
- So what I do is I take $100,000 of this cash.
- So I'm now left with just $225,000, and I have the great
- experience of going on a vacation.
- But of course I didn't get any asset in return for that.
- Although maybe your happiness is an asset, I don't know.
- But it doesn't show up on your balance sheet.
- So we had $325,000 in cash.
- Now we have $225,000 in cash.
- So our total assets went down about $100,000.
- What are our assets now?
- It's $1.725 right?
- Because we spent $100,000 of our cash.
- So what's going to be the liabilities and equity?
- Well the liabilities won't change, right?
- Just because I went on vacation, the bank's not going
- to say, hey Sal, you owe us less money.
- I still owe the almost $1.075 million.
- The $100,000 is going to come all out of my equity.
- So now all of a sudden I don't have $750,000.
- I only have $650,000.
- And this isn't the balance sheet just for my house.
- This is kind of my whole personal balance sheet.
- And now my whole personal balance
- sheet, what just happened?
- I just took some of that original equity that I had.
- I took $100,000 of it, turned it into cash, and just went on
- a great one-year-long vacation.
- And this is what home equity loans are.
- And this is what, I would argue, drove the economy.
- Or at least took us into an expansionary stage
- from 2002 to 2003.
- Because if you remember, a lot of people were still getting
- laid off in 2002, 2003, but consumer
- spending kept going up.
- So people are earning less money, or they
- don't even have a job.
- How is spending going up?
- Well, the values of their house went up, and they
- borrowed against the value of their house.
- They took cash out of it, and they used that cash to buy
- their Hummers, to go on vacation, to buy fancy
- clothes, whatever.
- And that drove the economy.
- And in the next video I'll actually talk about, maybe,
- why those housing prices go up.
- Or why they went up, in particular, during this
- housing boom, this one that we're definitely in the
- process of getting out of.
- See you in the next video.
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