While reading through big short , I came across this sentence, ‘People with first mortgages had vast amounts of equity locked up in their houses’. What does this mean.
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When you buy a house, you usually do it with some of your money (the down payment) and some money from a bank (a special loan called a mortgage). The difference between the value of your house and the balance left on the mortgage is called equity.
You can’t spend equity directly: to get access to it, you’d have to sell the house, and then where would you live? So those funds are “locked up” in the house itself.
It means your house has value. If you take a mortgage to buy the house, most of that value is locked up in the loan. Basically, you have a house with say $300k in value. But you owe almost $300k to the bank. So the two cancel out. Building equity is what happens as you pay that loan down.
For an easy example, say that home will always have a value of $300k. As you pay down the loan you build up equity. So lets say you reach a point that you’ve paid off $100k of the loan. You know have $100k in equity in the house.
What they are saying is that you now have $100k of value just sitting in the house doing nothing. Unlocking the equity would mean refinancing or taking out a second mortgage on the house. This would allow you to “pull” the $100k of equity out of the home and into cash. The downside is you now have to pay off that same amount of money again. The upside is you have the money to invest into something that will hopefully return more than the interest on the new loan.
With regard to the big short I think they may have been referring to the equity that is gained from the asset appreciating in value due to market conditions/demand/speculation. In some markets houses were like doubling in a few years.
Example: I make $100K per year and, with decent credit and some down payment I bought a $400K house in 2018. The total house payment, with property taxes, etc., is, say $2500/mo. The bank decided I could afford a maximum of $2600/month for a moetgage payment, based on my income and debts. They ran sample probable totals for taxes, insurance, principle and interest all added together when I was applying for the loan, and that is how I arrived at an approximate price of $400K for a house when I started house hunting. (That’s like being a “prequalified buyer”.)
Now it’s 2022. The value of the houses has gone up in the last 4 years. Zillow sent me a market estimate for selling price of my house as $650K. My income has gone up to $110/K per year. Fortunately for me, I still pay “only” $2500/month on my house because I bought it when it was $400K. The reason that is fortunate is because I can’t buy my house new today. I only make $10K per year more. I have ZERO incentive to sell my house right now, even though I would, (in theory, but in real life there are seller’s fees) walk away with $250K. If I wanted to put that $250K down on another house, with all the fees involved with selling and re-buying it would only be about $200K. With my $110K/mo income, I can only make payments on just north of a $400K loan. $200K in the down payment from the sale of my other house plus the $405K loan amount I am approved for equals $605. The house I just sold was $650, so that means I downgraded my house. That is why people just stay on their houses. They can’t afford to sell and re-buy in the same neighborhood. I could borrow against that $250, but it’s not that easy, with banks requiring a loan application to see if I have 20% paid in the house (to prevent a potential PMI fee) AND am able to pay the second loan payment in addition to the $2500 current monthly payment. Or I could refinance entirely and take out some of the $250K (again, banks will want to see that base 20% intact) and have a single higher monthly mortgage payment, which will re-start a new 30 year loan. This is a lengthy example, but it shows how difficult it is to liquidate the quarter million dollars inequity my home has. That’s a really good real-life example of why there’s eqity “locked” in houses.
(Edited with my cheaters on for grammar)
* When you buy a house, the loan you get is backed by the house itself.
* If you fail to pay, the house gets auctioned off and the money collected from the sale first goes to the bank and the rest you get to keep.
* The part you get to keep is called equity.
* But you can actually use that part without selling your house.
* You can take out a second loan on just that part.
* So now if you don’t pay and the house gets auctioned, the money goes to those banks first and then you keep what’s left.
* The difference between what you owe on your mortgage(s) and what your house could be sold for can increase quite a bit if homes prices in general go up.
* This is what they are talking about in the Big Short.
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