Build Home Equity Faster

Equity is the part of your property that you actually own. It's the current value of a property less the amount of the liens secured against it. If you own property that's worth $250,000, and you have a mortgage with a remaining loan balance of $100,000, your equity in the property is $150,000. Repeat home buyers usually rely to some extent on the equity in their current home to help buy their next home. The more equity you have, the larger the possible down payment for the trade-up home.

Home equity also equals security. The more you have, the better off you are, the more financial leverage you have, the more stable you feel. So how do you build home equity faster? Especially at the beginning of a mortgage loan, so little of your payment goes to principal that equity builds maddeningly slowly.

Naturally, building home equity comes at a price, usually in the form of larger payments. One trap you want to avoid is becoming house-rich and cash-poor. If building home equity means incurring debt to make ends meet, then you've defeated the purpose of building equity in the first place.

The first option in home equity building is to make additional principal payments. One way to do this is to sign up for a bi-weekly mortgage, in which you make two payments per month (which added together equal one monthly payment). You will make the equivalent of 13 monthly payments per year instead of 12, which may seem insignificant. But a 30-year loan with a bi-weekly payment plan is usually paid off in about 20 years.

To compare this option to other ways of building your financial security, let's look at additional principal payments in contrast to investing. Additional principal payments make sense when you save more on your mortgage interest expense on an after-tax basis than you would earn on your investments on an after-tax basis. If you are able to deduct your mortgage interest from your income taxes and your marginal federal income tax rate is 27 percent or higher, then your after-tax cost of mortgage debt is between 3 and 4 percent.

In the current economy with its low interest rates, the after-tax return on money market investments and CDs won't offset your after-tax cost of debt. For instance, if you earn 4 percent pretax on a five-year CD, and you're in the 27-percent bracket for federal income taxes, the after-tax return is less than 3 percent.

However, contributing to a tax-advantaged retirement account, especially a 401(k) plan where your employer matches all or part of your contributions can be a better strategy than prepaying your mortgage -- at least up to the limit of the employer match.

Before you start making additional principal payments, use one of the many amortization calculators you can find on the internet to do the math-how much interest you would save if you made additional principal payments, and how much it would shorten your loan and increase your home equity.
The other way to build home equity faster is to refinance. Recently, the reason most people have refinanced is to lock in a lower interest rate and/or lower their monthly payment. But you can also refinance to shorten the term of your mortgage, which builds equity. The down side to this is that a 15-year mortgage is harder to qualify for than a 30-year.

If you had a $200,000 30-year ARM at 8.13 percent and replaced it with a 15-year fixed rate loan at 6.75 percent, your monthly payment would go from $1485.69 to $1769.82. But the total interest on the 15-year loan will come to $118,567.29 as opposed to the $334.855.28 on the remaining life of the ARM, assuming your adjustable rate holds steady at its current 8.13 percent. So in addition to saving more than $200,000(!), you build the same amount of equity in half the time.

But what if you can't afford a higher house payment? Your next best means of building equity is to refinance for less than 30 years. To do so, ask your mortgage company to customize your new loan's term to match the years that are left on your old loan -- if you are five years into a 30-year mortgage, for example, ask for a 25-year loan.

You probably won't receive the entire amount of your equity as cash when you sell your home. Most sellers use part of their equity to pay selling costs, such as brokerage commissions and transfer taxes. Also, if you are delinquent on your property taxes, or have other liens secured against the property, such as an IRS tax lien, these would have to be paid at closing.

In past years, homeowners saw their equity grow significantly due to home price appreciation. Appreciation is the increase in the value of a property. Picture this: You bought your first home for $125,000 in 1985 with a 10 percent down payment of $12,500 and a mortgage for $112,500. By 1989, your property had doubled in value to $250,000. After you paid back the mortgage and your selling costs, you were left with about $122,000 in cash.

For more information on this article or assistance with your San Diego real estate needs contact Noel Wheeler of Prudential California Realty at (619) 718-4266 or visit http://www.noelwheeler.com/

Should You Borrow From Your 401k?

Have you refinanced your home into oblivion? Tapped out every available money resource with a myriad of loans and credit cards? There is one last option: borrowing from your 401(k). If you've never heard of this option, it's because until recently, it just wasn't done that frequently. But with the market still not fully recovered, and people desiring to cut their high interest debt, more folks are discovering this alternative lending source.

Before you decide to borrow from your 401(k), it is crucial that you understand the pros and cons. Don't forget that your 401(k) is your retirement nest egg, and you are putting that nest egg into possible jeopardy. If you're thinking of borrowing from your 401(k) to buy a luxury automobile or a larger home, stop. Mortgaging your future to live a lifestyle that's beyond your income is a mistake. But if you're trying to get out from under high-interest debt and plan to use this opportunity to live within your income, it could be your ticket to becoming debt-free.

Here's how they work: most plans allow you to borrow up to half of your vested balance, but not more than $50,000. You apply to the company that manages your 401(k) plan, but you don't have to "qualify"-after all, you're borrowing money from yourself. You sign a promissory note and receive the money within a couple of weeks. The interest rate is usually equal to the prime rate or slightly over. You have five years to repay the loan, and most of the time, you make payments through payroll deductions.

Now let's look at the pros and cons of borrowing from your 401(k):

Pros:

A 401(k) loan does not appear on your credit report. They are not reported to Experian, and do not become a part of your credit history.

The interest on these loans is typically lower than offered through most banks.

You're paying yourself the interest, not some bank.

You'll get your money more quickly than if you were using another means of borrowing.

Since it's a loan, you will not be charged the 10 percent early withdrawal penalties plus income taxes you would have to pay if you withdrew the money.

You don't have to qualify for the loan through the usual long, painful credit approval process, because in effect, you are the lender.

No assets or collateral are needed to secure the loan.


Cons:

The biggest con is that you are forfeiting the accrued interest you would earn if your money stayed in the 401(k). Calculated over the long term, it can cost tens even hundreds) of thousands of dollars in potential gain.

Unlike a home equity loan, the interest is not tax deductible.

Some plans do not allow contributions to the 401(k) for the period of the loan.

If you lose or quit your job, the loan is often due in full in 30-60 days although some plans are open to renegotiating the terms of the loan. Find out before you sign the papers.)

If you default on the loan, it is considered a withdrawal and you will owe a 10 percent penalty plus a hefty tax payment. So if you had borrowed $50,000 and couldn't pay it back, you would have to pay a $5,000 penalty and federal and state taxes that could take another $20,000 of the amount.


To calculate the actual cost of borrowing from either source: for a home equity loan, ignoring upfront costs, the after-tax cost is the interest rate minus your tax savings (interest rate times 1 minus your tax rate).

The cost of borrowing from your 401(k) is what your loan would have earned had you kept the money in the 401(k). Since your 401(k) accumulates tax free, the total return on the fund is a close approximation of the after-tax cost.

Let's say you need to borrow $10,000 and you have $100,000 in your 401(k) earning an average of 10 percent a year. Interest on a home equity loan is 8.5 percent and you are in the 28 percent tax bracket. The after-tax cost of the home equity loan is 8.5x(1 - .28) or 6.12 percent. The 10 percent cost of borrowing from the 401(k) is higher than the 6.12 percent cost of the home equity loan.

If both loans are repaid in full after one year: if you use a home equity loan, you will have $110,000 in your 401(k), you've paid the lender $10,850 in interest and you have a tax savings of $238. Your financial wealth will therefore be $110,000 - $10,850 +$238 = $99,388.

If you borrow from the 401(k), you will have only $99,000 in your 401(k) at the end of the year because you haven't earned the 10 percent on the $10,000 you borrowed. Whatever you pay back to the fund does not affect your wealth. You are thus $388 poorer if you borrow from your 401(k).

For more information on this article or assistance with your San Diego real estate needs contact Noel Wheeler of Prudential California Realty at (619) 718-4266 or visit http://www.noelwheeler.com/