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Studying for a test? Prepare with these 4 lessons on Housing.
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Video transcript
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 -- liabilities. 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.