House prices have been rising fast all over the UK over the last couple of years. Many people are experiencing a significant increase in their overall wealth as a result. In the United States, this has been termed the ‘wealth effect' with an increase in the value of people's homes being recognised as creating the confidence among consumers to borrow and spend more money and thus fuel the economy. The very same trends can be witnessed in the UK where people are using the equity in their homes to pay for more and more luxuries.

Basic Concept of Home Equity

The way this works is quite simple. Supposing you take out a one hundred per cent mortgage and buy a home for one hundred thousand pounds. Since you borrowed one hundred thousand, and spent one hundred thousand, you will have a net equity of zero, since your assets (the house) are equal to your debts (the mortgage). However, with increasing house prices, it is common for such a house to be worth say one hundred and fifty thousand pounds after a few years. This will now leave you with a positive equity of fifty thousand pounds, since you still only owe the bank one hundred thousand, or in fact probably less by now. You have increased your wealth by fifty thousand pounds without actually doing anything.

Unlocking the Equity

This extra wealth does not have to stay locked up in your house. What you can do is go to a bank, and ask them to lend you fifty thousand and secure it over the extra value in your home. If you do this, you will not have higher mortgage payments as the amount you owe the bank is higher, but you will also have fifty thousand pounds to spend as you wish.

Re-Invest In The Home?

You do not have to spend it all at once, but many people pay for home improvements or extensions with the money. This is generally a good idea, as since the debt is long term, you should spend it on something that will benefit you in the long term, and probably further increase the value of your home. Other people may spend the money on cars, shopping sprees and holidays, which may not be such a wise decision as you will be repaying the mortgage over the next twenty five years, but will have spend all of the money within a couple of months.

While the choice of how to spend the money rests with individuals, the fact of the matter is that more and more people are taking advantage of the equity in their home in this way.

Dangers of Home Equity Loans

Everything is rosy in the garden at the moment, but what would happen if you unlocked your equity, had the time of your life travelling around the world only to come back home to find that you have lost your job? In the example above you would not only be one hundred thousand pounds in debt, there would be another fifty thousand – the equity that you have just spent. This will result in increased mortgage payments that you will struggle to pay without any income.

The Housing Market Collapse

However, the most disturbing factor involved would be a change in the direction of the housing market. You may believe that your home is safe and can't lose value in an economy that never stops growing, but it can. During the Eighties in the UK we witnessed just that. In the first few years a fantastic boom were everyone seemed to have money, times were good, then suddenly the interest rates begun to rise in an attempt by the Bank of England to curb spending. Mortgage repayments for almost every household in the UK also increased and people started to downsize their homes in an attempt to decrease their monthly payments. The housing market became static and prices fell, pushing peoples mortgages into negative equity.

Precautions in Home Equity Loans

What this article hopes to impose on you is that you should never rely on any outside factors for your home. As any Las Vegas gambler will tell you, never ‘gamble' with a with things that you can't afford to lose. If you are considering a home equity loan then you should use the money carefully, the optimum use (and most common) is to re-invest in your home, increasing its' value.

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