What is Equity?

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What is Equity?

Equity is one of those terms commonly thrown around in the world of finance, yet many people may only have a limited understanding of what it really means. Looking at the term, it can mean something different, depending on the situation. Home equity means one thing, while equity for small business owners means something different.

A Look at Home Equity

Taking a look at equity as it relates to home ownership, it’s the value an individual has invested in his or her home. Essentially, the formula for figuring this out is simple. Subtract the balance of the loan still outstanding on your mortgage from the appraised value of your home. The answer is how much equity you have invested in the property.

When you borrow money from a financial institution to purchase real estate, that bank has a vested interest in the property. The equity, which you earn by making your mortgage payments and reducing your debt, is how much of the home you own. As you gain more equity in your home, you can use that as a resource, or an asset. You may need to refinance your home or request a home owners line of credit. In either case, the more equity you own in your home, the more value you have to offer as collateral.

There are two ways homeowners can increase the equity they have in their home. Most obviously, making mortgage payments and repaying the loan reduces your debt and earns you greater interest in your home. Conversely, it also reduces the interest the bank has in the property.

Another way to earn more equity is by increasing the value of your home. If you can make improvements and have your home assessed at a higher value without increasing your debt, your equity will increase. In some cases, a boom in the real estate market may raise the value of your home without any action on your part. This will also give you added equity, at least until the housing market takes a downward turn.

Small Business Owners Earn Equity Too

The definition for equity in business is similar, but with a slight difference. The formula here takes the difference between your assets in your business and what you owe, which includes both debts and liabilities. By calculating this sum, you can determine how much you actually own in the business versus how much your debtors own. This can be helpful in deciding to sell a business or to consolidate your debts.

Just like home equity, the amount of equity in your business increases as your assets increase, but, in the case of business ownership, assets include more than just how much interest you have in the real estate. Assets also include your number of clients and customers, your influx of profits, how much your brand is valued, and the potential for growth and franchise opportunities.

In cases where you take your company public and allow people to buy stock in your business, you can also earn shareholder equity. As the owner of your business, you will retain the majority of shares, which earns you more equity as individual stock prices for your company rise.

Homeowners and business owners often use the equity they have invested in their homes to make improvements. For homeowners, this may just be to add more value or to make the home more enjoyable. For business owners, they may choose to use the equity in their company to make improvements or upgrades that will enhance their earning potential. In either case, it’s important to maintain a record of your investments, because banks expect you to prove how much equity you have invested, before considering a loan.

What is Collateral?

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What is Collateral?

A common term when it comes to loans and lines of credit is collateral. If you’re interested in getting any type of financing that requires collateral, it’s important to fully understand what the term means. This guide will cover the definition of collateral, common forms of it and what happens to this collateral if a default occurs.
Types of Financing

You could break down all forms of financing, including both loans and lines of credit (which include credit cards), into the following two categories:

The only thing separating these two types of financing is the presence of collateral. A secured loan or line of credit must have some property of the borrower’s attached as its collateral. The lender can then legally repossess that property if the borrower fails to make their payments. An unsecured loan or line of credit only has the borrower’s personal guarantee that they’ll pay back what they borrow.

Common Forms of Collateral

There are many different pieces of property that a borrower can use as collateral on a loan or line of credit, although the collateral will depend on the lender and what that lender offers.

The two most common items that borrowers use as collateral are their homes and their cars, and the reason for this is that these are typically the most valuable items that a person will own.

It’s important to understand that there are multiple ways property could become collateral on a type of financing. If the borrower buys that property with a loan, then the property is automatically the collateral on that loan until the loan is paid off. A home is automatically the collateral on the mortgage used to purchase it, and a vehicle is automatically the collateral on a vehicle loan.

The borrower could also use property they’ve already purchased as collateral to secure financing. For example, someone with a paid-off car could use it as collateral to get a title loan. Or, someone who has paid into their home and has equity in it could use that equity to get a line of credit.

Although credit cards usually don’t have collateral, there are secured credit cards intended for those with bad credit. In this case, the cardholder pays a security deposit, and the money they pay is the collateral.

What Happens if the Borrower Defaults

The simple answer here is that if the borrower defaults on a secured loan or line of credit, the lender will repossess the collateral. In practice, it usually goes more like this:

  1. The lender waits a certain period of time after the payment due date in case the borrower is just late on their payment.
  2. The lender notifies the borrower of the missed payment and explains the possibility of repossession if the borrower doesn’t catch up on what they owe.
  3. The lender waits again to see if the borrower will pay.
  4. If the borrower doesn’t make their payment, the lender will initiate the repossession process.

Now, this process varies quite a bit depending on the situation. A mortgage may have a long, drawn-out repossession process, whereas with a title loan, repossession could happen the day of the default.

Collateral can be an excellent way to receive approval on a loan. Just keep in mind that whatever you put up as collateral will be at risk if you fail to hold up your end of the bargain on the loan.

What Is Refinancing?

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What Is Refinancing?

Refinancing is essentially replacing an existing loan with a new loan. There are many reasons to refinance, including getting a lower interest rate, taking equity out of a home (cash-out refinance), switching from an adjustable-rate to fixed-rate loan, or getting better terms. It can make sense to refinance if things have changed since you borrowed the money to begin with.

A Refinance Is a New Loan

Refinancing is more than adjusting your existing mortgage as it involves getting a new loan to pay off and replace the existing loan. This means you must go through the approval and underwriting process from the beginning. You will need to gather the same financial documents, search for a loan that fits your needs, and negotiate with the lender. Your credit will matter with a refinance, just as with the original mortgage. If your credit or finances have gotten worse since you took out the original loan, it may be harder to find a new loan that offers a better rate or terms.

Because it is a new mortgage, a refinance also comes with new closing costs. These costs can be thousands of dollars that are due when you close or may be rolled into your loan. It’s important to factor in closing costs when determining if refinancing makes financial sense.

Benefits of Refinancing

There are many reasons to refinance. Most people choose to refinance their loan for lower monthly payments. This can be the case if mortgage rates have significantly reduced since you took out your original loan. You may also get lower payments if you refinance into a loan with a longer term, although this will also increase your long-term interest costs.

You can also use a refinance to build equity faster. If you refinance into a loan with a shorter term, such as switching from a 30-year loan to a 15-year loan, your payments will be higher but more of your monthly payments will go toward your principal rather than interest.

When you refinance into a lower interest rate or a lower term, you can also enjoy long-term savings on interest. This can potentially save tens of thousands over the life of the loan. The longer you remain in the home, the higher your ultimate savings.

Another common reason to refinance is changing the type of loan you have. Adjustable-rate loans can be great in the beginning as they offer lower interest rates than fixed-rate loans, but only at first. These mortgages can be unpredictable with mortgage payments that may increase dramatically over time. You can refinance from an ARM into a fixed-rate mortgage for stability.

You can also access the equity in your home with a cash-out refinance. This option requires taking out a new loan with a higher balance than the remaining balance on your existing loan, but you may be capped to a loan-to-value ratio of 85% to 95%.

Refinancing Isn’t Always a Good Choice

There are situations in which a refinance will not offer financial benefits. If you have had your mortgage for a long time, for example, most of your payments go to principal to build equity rather than interest. Refinancing late in a home loan can restart the amortization process and put most of your payments toward interest.

If you plan to move in the next 5 years, refinancing may not be in your best interest. The savings you will gain from a better interest rate or lower payments may not cover the costs of refinancing.

It’s also important to understand that some mortgages have a prepayment penalty that lenders charge if the loan is paid off early. This prepayment penalty will need to be factored into other costs of refinancing to determine a break-even point.

What is a Debt-to-Income Ratio?

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What is a Debt-to-Income Ratio?

In finance, there are a lot of different mathematical formulas used to calculate how well a company is doing. But the debt-to-income ratio is one of the best of them overall. That is because it is reflective of how likely a company is to be successful at financially staying afloat.

How do You Calculate the Debt-to-Income Ratio?

The debt-to-income ratio is calculated by dividing the total amount of debt by the total amount of income that a company has. The debt figure has to include both long-term and short-term debt amounts. And the income calculation must be the same, especially in regards to any revenue that it expects to achieve.

Who Needs to Use the Debt-to-Income Ratio?

The division of the amount of debt by the amount of income will result in a percentage, which is needed by banks and financial investors. If it is too high, then it will be difficult to get funding. If it is too low, it will show that the company is not attempting to achieve any growth. Overall, a good number to have is less than 48% though.

How Can a Company Lower Their Debt-to-Income Ratio?

A company who has been turned down by banks or investors will have to work at changing their financial statements to reflect that they have been attempting to pay off their debt. They may do this by demanding payment from customers who owe them money, selling assets to increase their cash flow for debt payoffs, or making changes to increase the amount income that they will be getting.

What Happens if a Company Continues to Carry too Much Debt?

If a company doesn’t make the changes that it needs to lower their debt-to-income ratio, there is a good chance that they will lose the few investors or shareholders that they already have. No one wants to stay in a sinking ship. And too much debt means that a company isn’t going to look appealing to any new investors either. Bank loans and lines of credit will also be difficult to get approved for.

What is Principal?

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What is Principal?

If you are working with any kind of financial product, it’s important that you know the terminology. It’s not just about being able to speak to a loan agent intelligently – it’s about being able to make informed decisions about the products that you might choose to purchase. One of the most important terms you can know when looking for a loan is ‘principal’, one of the first terms that you’ll see when filling out the relevant paperwork. Understanding the basic definition of this term as well as how it will function in regards to your loan is a good first step in figuring out whether a loan is right for you.

The Definition

Principal is a term with a few financial meanings. It can, for example, refer to a party to a transaction in many contracts. When it comes to loans, though, the term is almost always used to specify the amount of money that will be borrowed. If you are taking out a five thousand dollar loan, for example, the principal balance of the loan will generally be five thousand dollars. This may not be all of the money you will owe, but it’s the money that you will receive.

Principal Balance

Typically speaking, this is what you’ll be working to pay off after you take out a loan. Your payments will typically go partially to the principal and partially to interest. Extra payments made on your loan will typically go towards the principal balance. All calculations of fees and interest are usually related to this balance as well, making it one of the most important things you’ll need to know. The faster you manage to pay down this part of your balance, the faster you will be able to pay off the entire loan.

Why it Matters

For many borrowers, knowing the principal amount of the loan is the most important thing they’ll hear from a lender. This is the amount of money needed by the borrower, though sometimes the money received will not actually be the same as the total of the principal balance. If a borrower is unaware of the principal, he or she might not know how much he or she is borrowing – or even how much he or she should be receiving from the loan originator. Understanding this term allows one to plan how to use the borrowed money.

At the same time, an understanding of this concept generally allows for better financial planning. If you know what the principal is on your loan, you know how to calculate the interest payments. While it might involve a bit of math, it’s very simple to figure out how much you’ll pay over time. This, in turn, allows an individual to know whether or not to accept a loan at a specific interest rate. While it’s always a good idea to accept a lower interest rate, having an idea of how that rate will be calculated will help an individual to determine if it’s feasible to accept a loan at a higher rate.

Principal is absolutely one of the terms that a borrower must know before taking out a loan. As it refers to the sum that the borrower wishes to borrow, it will be stated multiple times in a lending agreement and many of the most important aspects of the loan will be related back to that amount. Take some time to learn a bit about the financial terminology related to your loan; doing so will not only make it easier to understand the agreement, but it can also help you to make better borrowing decisions.

What Is Annual Percentage Rate (APR)?

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What Is Annual Percentage Rate (APR)?

Annual percentage rate is the annual rate you pay to borrow money or what you earn each year on an investment. APR better represents the true cost of a loan than an interest rate as it includes fees and other costs. An APR can be used to make better comparisons between loan options than interest rate alone. In general, an APR is about 0.20% to 0.25% higher than the interest rate.

It usually makes sense to choose a mortgage with a lower APR, but a loan with a better APR may require paying more points or additional fees. On the other hand, choosing a loan with a slightly higher APR can be a better choice if the money would be better spent on a down payment.

What Is Included in an APR?

While the annual percentage rate is designed to give consumers a more realistic idea of their loan cost each year, you may not necessarily be comparing apples to apples when using the APR. This is because lenders do not need to include all costs you will pay in the calculated APR for a loan.

Many fees will not be included in the APR, including credit report fees, inspection fees, and appraisal fees. Each lender can choose how much they charge for credit reports. Fees that are included in the APR include origination fees, discount points, most closing costs, and mortgage insurance premiums, when necessary. Because mortgage insurance is included in the APR, be sure you aren’t comparing the APR of a loan with mortgage insurance against the APR of a loan without mortgage insurance.

An APR Assumes a Full-Term Loan

It’s also important to remember that a loan’s APR assumes you will keep the loan until it’s paid off without making additional payments. The APR on a 30-year fixed mortgage, for example, assumes you will keep the mortgage for 30 years and make only the scheduled monthly payments. Most people do not do this, of course.

This matters because a loan may have a low APR but high upfront fees and a lower interest rate. If you sell the home or refinance after 7 or 8 years, the cost of the upfront fees will not be spread over the life of the loan and your APR will actually be higher.

APR and Adjustable-Rate Mortgages

APR is only effective in terms of fixed-rate mortgages as the interest rate will remain the same for the entire loan term. The long-term costs of an adjustable-rate mortgage are impossible to predict with an interest rate that usually begins low but increases after 1 to 10 years.

A loan’s APR should be considered a starting point to compare mortgage quotes and understand the costs of a fixed-rate mortgage, but it is not the only important factor to consider. It’s also important to think about how long you plan to remain in the home when choosing a mortgage. High upfront fees and a low interest rate tend to work best if you will remain in the home for a long time, but a higher interest rate and lower upfront costs will probably work best if you will sell the home or refinance in the next five years.

What Is Pre-Approval?

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What Is Pre-Approval?

It’s often recommended to get pre-approved for a mortgage before shopping for a home. Pre-approval is a process in which you submit credit, income, and debt information to a lender for a preliminary loan application. While pre-approval is not a guarantee that you have the money to borrow, the lender will help you learn how much you can borrow, the rate you can receive, the type of loan program, and the terms of the loan. Pre-approval also gives you bargaining power when you make an offer on a home.

The Pre-Approval Process

The pre-approval process begins by providing basic information about yourself and your financial history. Your lender will also request your Social Security number to perform a credit check.

During the pre-approval process, your lender will verify your documentation and credit information to determine if you can be approved for a loan and the amount and terms. You will need the same documents to get pre-approved as you will during the actual loan process, including:

  • Pay stubs
  • W-2s for the last 2 years
  • Bank statements for all accounts for the last 2 months
  • Tax returns for the last two years
  • A list of monthly debts not listed on your credit report
  • Current real estate holdings and loan balances
  • Statements for other assets such as stocks and securities

Each lender uses its own standards to determine when a pre-approval letter will be issued. If you cannot get pre-approved, there are steps you can take before reapplying. Work to improve your credit score by paying down debt and correcting negative or incorrect information, when possible. Paying down debt will also improve your debt-to-income ratio. You may also need to increase the size of your down payment.

Why Get Pre-Approved?

According to most real estate professionals, offers that come without a pre-approval are often rejected right away. Without pre-approval, a lender has not verified that you can even get approved for a loan with sufficient income and credit.

The benefits of pre-approval go beyond making a solid offer on a home, however. The pre-approval process can also help you understand where you stand, how much you can borrow, and what you will pay for a mortgage. This can be invaluable ahead of a home search as you can narrow your focus and prepare a reasonable budget.

Pre-Approval Is Not a Loan Guarantee

Receiving a pre-approval letter does not guarantee a loan or a specific rate or term. Lenders may also require additional verification of your income and assets as well. Pre-approval letters are usually subject to change or cancellation if your financial situation changes. While a pre-approval is not an offer to lend, most people have no trouble qualifying for a mortgage with their lender after the pre-approval process.

Pre-Approval Is a No Obligation Process

You are under no obligation to take out a loan when you are pre-approved. You may decide to take out a mortgage under the terms you are offered, or you may go with a different lender. It’s also possible for a lender to not actually make a loan for which you have been pre-approved, although this usually only happens if circumstances change.

What Is a Balloon Payment?

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What Is a Balloon Payment?

A balloon payment is a large one-time payment that is due at the end of a loan. Mortgages with loan payments usually have lower payments in the years leading up to the balloon payment. This is because the loan only requires that borrowers pay interest for the first few years, allowing the balance to grow. Balloon loans are not nearly as common as they were in the past, but they are still offered to well-qualified borrowers.

How a Balloon Payment Loan Works

A balloon mortgage does not fully amortize over the life of the loan. This means there is a balance remaining when the loan is due. This happens because a balloon loan requires interest-only payments for the first few years of the loan. With a standard loan, every payment goes to interest and principal to reduce the balance of the loan. Interest-only payments can dramatically reduce the monthly payments, but the interest will continue to accumulate.

Balloon loans are most often found in commercial real estate loans than residential loans, although some home mortgages still have balloon payments. The typical balloon payment is around 2x the average monthly payment on the mortgage, but it may be tens of thousands.

When a Balloon Payment Makes Sense

With a balloon loan, your monthly payments are lower in the initial stage of your mortgage. Because this feature is considered a higher risk, it’s usually only available to borrowers with excellent credit and stable income.

The ability to finance a home purchase with lower monthly payments can be a big advantage to qualified buyers. Most borrowers do not even make the balloon payment when the term ends. If you qualify, you can refinance to avoid paying the lump sum or sell the home. This also makes balloon loans attractive to buyers who do not plan to live in the home for very long.

Drawbacks of a Balloon Loan

While a balloon payment can make sense for some borrowers, it’s not the right choice for everyone. With most balloon loans, a lump sum balloon payment is due 3-7 years after taking out the loan.

Because balloon loans only require interest payments for the first several years, you will not build equity if you do not make additional payments toward principal.

Balloon Payments Aren’t Allowed with Qualified Mortgages

Qualified mortgages are loans with certain stable features that are designed to help consumers afford their mortgages. When a lender offers a Qualified Mortgage, it means the lender followed the federal ability-to-repay rule.

Qualified Mortgages do not allow excessive upfront fees and points and limit how much income can go toward debt. They also ban certain risky loan features like negative amortization and balloon payments. In exchange for meeting these qualifications, lenders get better legal protection.

What is Repeat Borrowing?

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What is Repeat Borrowing?

Repeat borrowing is a common problem for borrowers of short-term loans with high interest rates. Here’s everything you need to know on repeat borrowing, from exactly what it is to what makes it so dangerous.
How Repeat Borrowing Works

Just like the name suggests, repeat borrowing is when a person borrows multiple times in a row, with each new loan they borrow covering the balance of the previous loan. This happens all the time with short-term loans, such as payday loans and car title loans, but hardly ever with long-term loans. That is all due to the way the loans are structured.
With a payday loan or car title loan, the typically loan process goes like this:

  1. The borrower receives the loan.
  2. At the end of the term (typically two weeks for payday loans and one month for title loans), the borrower’s full payment is due, which includes the amount they borrowed and any financing charges, such as interest.
  3. The borrower can either pay the full amount or pay only the financing charges, and then start a new term with new financing charge for the same amount as before.

Repeat borrowing could also be considered extending the loan. This doesn’t happen much with long-term loans because those have equal installment payments, allowing the borrower to gradually pay off their loan in smaller amounts over a period of months or years.

Why People Borrow Multiple Times

There are only two reasons why anyone would borrow a new loan to cover an old one:

  • They don’t have the money to make their full loan payment.
  • They can obtain better terms on their loan.

And that brings us to the key difference between repeat borrowing and refinancing, another common loan term. With repeat borrowing, the borrower is only getting a new loan because they can’t pay, and it isn’t saving them any money through a lower interest rate. In fact, it’s costing them more money.

When you refinance a loan, you’re applying for a new loan so that you can use it to pay off the old loan completely. You’re then able to repay the new loan with its better terms. The most popular reason to refinance a loan is to get a lower interest rate, but a borrower could also do so because they want to lower their monthly payments or change the length of their loan’s term.

The Dangers of Repeat Borrowing

Refinancing a loan can sometimes be a sound decision, but repeat borrowing never is. The problem with repeat borrowing is that it leads to a cycle of debt. This is where you only pay enough to extend your loan each time, but you never actually reduce the loan principal amount. Instead, all you’re paying back is the financing charges.

Let’s say that you get a $1,000 car title loan with $200 in interest. At the end of the month, you’re supposed to pay $1,200, but you can’t. You pay $200 to start a new term, and once again, you owe $1,200. If this process continues for five months, you’ll have paid $1,000, but you’ll still owe $1,000.

That’s the problem with repeat borrowing – you only pay enough to keep yourself afloat, while staying in debt for the same amount. It’s just like if you only pay the minimum on a credit card. To avoid repeat borrowing, make sure you always have a plan for how you will repay a loan before you get it.

What Is Loan-to-Value Ratio?

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What Is Loan-to-Value Ratio?

Loan-to-value (LTV) ratio is a common tool lenders use to assess the risk of a loan. The LTV ratio of a loan is basically the size of the mortgage balance as a comparison to the underlying property value. Your LTV ratio is crucial when buying a loan as it can determine whether you will be approved and whether you need to buy mortgage insurance. Your loan-to-value ratio will also be important if you ever want to access your home equity with a loan or line of credit or you decide to refinance your mortgage.

Here’s how your loan-to-value ratio is calculated and when it’s used.

Calculating Loan-to-Value Ratio

The LTV ratio is the ratio between your loan amount and your home’s value, or its purchase price. To calculate the LTV ratio, divide your loan amount by the purchase price or home’s appraised value. For example, if you are buying a $150,000 home with a $30,000 down payment, your loan amount will be $120,000. This gives you an LTV ratio of 80%.

Why It Matters

Lenders place a great deal of weight on an applicant’s loan-to-value ratio when underwriting a loan. The lower the LTV ratio, the lower the interest rates for which you can qualify. This is because you are viewed as a better risk.

Lenders do not want to take your home; they want to be paid back on time and as quickly as possible. The lower the LTV ratio, the greater the amount of equity you have in your home. This reduces the risk that you will default on the mortgage. If you do default and the lender needs to foreclosure, they will be better able to recover the amount of the loan.

It isn’t just during a loan application that LTV ratio is used; this important factor is also considered if you want to refinance or take out a home equity loan or HELOC.

LTV Ratio and PMI

If you are applying for a conventional mortgage, your LTV determines whether you must pay private mortgage insurance (PMI). PMI is a type of insurance that protects the lender if you default on your loan. It can add more than $100 to your monthly mortgage payment. With conventional loans, you must put down at least 20% to avoid PMI, which gives you an LTV ratio of 80% or lower.

LTV Ratio and Home Equity Loans

The size of your down payment when you buy a home directly lowers your LTV ratio. Your LTV ratio can also change for better or worse with changes in the value of real estate in your area. As your home increases in value, you will gain home equity and lower your loan-to-value ratio. Making mortgage payments also steadily decreases your LTV ratio.

When you decide it’s time to access your home equity, your LTV ratio will again be considered.

Lenders usually use a metric called a closed loan-to-value (CLTV) ratio when you refinance. Your CLTV is the balance of your current mortgage plus your desired equity loan divided by the value of your home. You may be able to borrow up to a CLTV of 90% to 95%, but most lenders require a CLTV of 85% or less.

Loan-to-Value Ratio and Refinancing

LTV is an important factor in determining if you can refinance your mortgage and how much you will pay in fees and interest. While it is possible to refinance with just 5% equity, doing so can be expensive. If your LTV ratio is at least 80%, lenders will typically waive mortgage insurance and offer better interest rates and terms.

Your LTV ratio isn’t everything as your credit score, income, and other assets will also be big factors in determining whether you qualify for a loan and how much you will pay. Still, it’s important to keep your LTV ratio as low as possible to reduce your borrowing costs and keep other options open in the future.