Learn about Home equity loans

Khan Academy Presents: Simple example of borrowing from equity to fuel consumption

Welcome back. In the previous video, we had this very positive scenario where I had originally bought a house for a million and a half million dollars. 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 neighbor sold their identical house for $1.5 million. And so, my initial equity investment went up to $250,000 to $750,000, and why is that? Well, equity is nothing but—if I have an asset that’s worth a million and a half 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 kinda 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 a hundred percent sure we are, but definitely until about 2006. So what’s a home equity loan? Well, I go to the bank and I say, “Well, I have this $750,000 equity. I wish I’m rich but I don’t have this in cash. I want to do something with that equity. I would like to live like a rich person.” And all the banks say, “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” 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, etcetera, etcetera. So they said, “We’re willing to loan 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 x 75%, let’s see. It would be $750,000 plus half of $750,000, it will be I think $1.075 million. 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 loan you up to 75% of the value of your asset” and of course, it’s going to be guaranteed by this asset. “So far, we lent you $750,000. So you have—let’s see how much you have more that you can borrow from us.” We’re talking in millions, so that’s 0.075, so 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 off? 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? Well, I still have a 1.5—let’s say I take this loan. Let’s say I say, “Great! I want $325,000 of cash. I want it right now.” So what happens? Let me draw another series of—another balance sheet. I’ve stopped using the word balance sheet. That was the original purpose of this whole discussion. Draw it a little bit bigger. Remember, liabilities plus equalities 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 could call that—well, let’s see, $325,000 cash. You 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 the liabilities on the side. Well, not the whole side. We’re going to have equity down here, so this is liability, $350,000. And then, I took a new loan to get this $325,000 of cash. So I have a new loan here, $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? So let me just make everything clear. These are the liabilities. These are assets, and equity is what you have left over. So what are my assets? I have $1.825 million in assets minus—now, what are my liabilities—minus $1.075 million. That was the max that I could borrow. Assets minus liabilities is owner’s equity, so let’s see, $825,000 minus $75,000, 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 that, 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 across or 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’m just as rich as they are So I decide to go out and I’m willing to spend $100,000 on the 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 pretty cool as a car gets to pure consumption. Let’s say that neighbor went on an around 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 you could maybe—your happiness maybe is an asset, I don’t know, but it doesn’t show up on your balance sheet. So we took—we had $325,000 in cash, now we have $225,000 in cash, so our total liabilities go down by $100,000. So our total assets went down by $100,000. What are our assets now? It’s $1.725 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 a vacation, the bank is not going to say, “Hey Sal, you owe us less money.” I still owe almost $1.075 million. That $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 to 2003 but consumer spending kept going up. So if people are earning less money or they don’t even have a job, how is spending going up? Well, the values of the 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 a vacation, to buy fancy clothes, whatever, and that drove the economy. In the next video, I’ll actually talk about maybe why those housing prices go up or why they went up and 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.