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Home equity loans

Home equity is the value of a home minus what is owed on the home. In some cases, homeowners can take out loans using that value as collateral. Explore how home equity loans work, and why someone might want one, in this video. Created by Sal Khan.

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  • blobby green style avatar for user Leonardo Ricardo Arvate Alvares
    What if the market value of the house by any reason depreciates to less than the $750k of liability? Is the equity going to be negative? If yes, how could that happen whether the concept of equity is related to what one has, not what one owes (that would be the liability if I understood).
    (17 votes)
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    • leaf green style avatar for user Dhananjay Gavade
      $750K is loan taken from bank & it is liability , that need to pay back to bank irrespective of market value of house. So even if values of house fall below $750K, you need to pay back to bank loan amount. The owner's equity is Asset minus Liability, if asset value fall down than Liability then owner's equity will be negative. If that negative value more means person moving towards bankruptcy.
      (19 votes)
  • blobby green style avatar for user Tanuj Sharma
    What is the point in the bank giving out a home equity loan? If the borrower has more equity due to an increase in the value of his/her house, shouldn't the borrower be using some of that extra money to pay off the mortgage rather than asking for a second loan? Why does the bank agree to a second loan?
    (15 votes)
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  • spunky sam blue style avatar for user Sarvothaman Madhavan
    Do these concepts of finance and economics apply all over the world? Or they based on US economics?
    (4 votes)
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  • leaf green style avatar for user Ari Aaron Aal
    I understand his current calculations, but arent mortgage rates closer to 3 percent then they are to 6?
    (6 votes)
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  • blobby green style avatar for user fede.grosso8
    i feel like we're missing the interest rates in this discussion. Am i right or wrong?
    (4 votes)
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  • leaf green style avatar for user Steven Pietrusza
    So, I have a quick question. These home equity loans are just for people who want to spend their equity as real money? I think I'd prefer to sit on the equity as security in case the house depreciates.
    (4 votes)
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    • male robot hal style avatar for user Andrew M
      They may want to spend it, or they may want to invest it in something else, like stocks.

      If you really need money - for an emergency, say, or maybe because you have become unemployed and your savings are running out - then a home equity loan could be your cheapest source of funding. Personally I think it is a good idea to have access to a home equity line of credit but not draw on it at all except in case of dire need. If you wait to get a home equity loan until you really need it, you might not be able to get it.
      (5 votes)
  • starky ultimate style avatar for user om kannan
    I'm confused. First, he has 750k in equity, he takes $375k of that out as a home equity loan (which then becomes cash/asset) which should leave $375 of equity in the house (and thats 375 not 325 bc of the math miscalculation?). Right? Why doesn't left side of the balance sheet look like this: 750k is original mortgage, 375k is liability in home equity loan, 375k equity in the house? Why does he still have $750 equity in the house if he took out $375 equity to spend. Please help.
    (5 votes)
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  • starky sapling style avatar for user Chunku Chunku
    OKAY, SO ...
    1. When the asset appreciated to $1.5M (original being $1M = 75% Liability + 25% Equity), my owner's final equity tripled and therefore I now have $750K excess equity,
    2. Now I go to the bank to ask for HEL for physical wealth ($$$) and the bank loans me another 75% of a liability as (L=A - E).

    My Questions are:
    a. When I sold the asset at $1.5M, how did I sell it? What was the method of receiving the payment that made me had to go to the bank for HEL?
    Because if I sold the house via cash/cheque, I could just pay off $750K debt to the bank and I'll have left $750K equity. This way, even if I did not go to the bank and not get HEL, I would have the extra $$$ on hand anyway, considering the fact that the asset no longer belongs to me anymore. Correct?

    b. With that being said, if I did the above, would the bank be able to tell the asset is no longer mine? If so, does what happens next have anything to do with me getting the HEL? OR does the bank only have connection with the liability ($750K) it gave me, and therefore method a. is completely safe and okay?

    c. When I first decided to own an asset worth $1M, my initial equity was $250K and my liability was $750K to the bank. Now, when I received my liability, the bank wanted me to make down payments worth say 20% of the $750K its lending me which is (750K x 20% = 150K), $150K that is also coming from my equity. Then, in actuality my initial equity literally was (250k + 150K) $400K?

    d. My last question is when I pay off the $750K back to the bank, how much do I actually need to pay? Because I already made the down payment of 20% ?

    Maybe I don't understand it well but either way I'm so confused.
    (3 votes)
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  • purple pi pink style avatar for user Purple
    What is an equity? At he states "So my equity just tripled" I am confused, is it a mortgage or the actual house loan?
    (2 votes)
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  • starky seedling style avatar for user Mirror
    dang i wish i was Sal, bro got a 1 million dollar house
    (2 votes)
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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.