Welcome back! In the previous video we had this very positive scenario where I had originally bought a house for $1.5 but 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 from $250,000 to $750,000 and what is that?
Well equity is nothing but if I have an asset that is worth $1.5 and I owe $750,000 that was my original mortgage on that asset then what I am left with is the equity. So my equity just tripled; it went from $250,000 to $750,000.
In this video, what I am going to do is I am going to show you, well, what can you do with that equity? I mean it's not cash, it's kind of like this make believe amount of wealth that you have. You just feel richer and I will show you that you can actually turn it into cash using something called a Home Equity Loan and I would argue that this is actually what drove our economy from about 2002 to probably still to this day; although, I think we are in a recession now; in fact, I am about 100% sure we are, but definitely until about 2006.
So, what is a Home Equity Loan? Well I go to a bank and I say, well bank, I have all this -- I have this $750,000 of equity I wish, you know, I am rich, but I do not have this in cash, I want to do something with that equity, I would like to live like a rich person.
Well, the bank says, Sal, you know, you are right, our only requirement is that you have 25% equity in your house, right; because they want a cushion in case you can't pay and they get the house back and they have to foreclose and auction of the house, etcetera, etcetera. So they said, "Well, so we are willing to loan you up to 75% of the value of your house." So what is 75% of the value of my house? So let us see 1.5x75%, let's see $750,000 plus half of $750,000 that will be $1.0750 I think $1.0759. I did that is my head, it could be wrong, but it's roughly the right number.
So the bank says, "You know what, we are willing to lend you up to 75% of the value of your asset and it's, of course, going to be guaranteed by this asset." So far we lent you $750,000; so you have, let's see how you have more than you can borrow from us. Minus, we are talking in millions so that is $0.075 so that's about that's $250,000 plus $75,000 so up to $325,000 more that you could borrow and what is this? Where I am taking money out of?
Well I am essentially taking this money out of the equity of my house and how does that make sense? Well what's going to happen? Let us say I take this loan, let's say, I say, "Bank great, I want $325,000 of cash. I want it right now." So what happens? Let we draw another series of assets -- another balance sheet. I have stopped using the balance sheet even though that was the original purpose of this whole discussion. I'll draw it a little bit bigger, remember liabilities plus equities are equal to assets. So what are my assets now? So, now, I have $1.5 million house and I also got $325,000 cash from the bank; so we could call that -- you know, let's say $325,000. $325,000 cash, 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 liabilities, on this side; well not the whole side we are going to have equity down here. So this is liability $750,000 and then I took a new loan to get this $325,000 of cash. So I have a new loan here, let us put that amount, $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 left over equity? So let me just make everything clear. These are the liabilities, these are assets, and equities - 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, right, that was the max that I could borrow liabilities, right; 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 debt my equity shouldn't change.
But now what does happen? Well I have this cash and I am feeling rich because I have never seen numbers like $750,000 and that neighbor, that new neighbor that just bought that house 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 am just as rich as they are.
So, I could decide to go out and I am going to spend a $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 close as a car gets to pure consumption.
Let's say that neighbor went on a round-the-world vacation for $100,000 and I too, because, I did nothing but sit on my house and made $500,000; I feel that I also deserve $100,000 vacation. So what I do is, I take $100,000 of this cash so I am 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 can be maybe -- your happiness maybe as an asset, I don't know, but it doesn't show up on your balance sheet.
So, we had $325,000 in cash now we have $225,000 in cash. 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. Just because I went on vacation the bank is not going to say, "Hey! Sal, you owe us less money,' I still owe, though, almost you know $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 you could do it.
And this is not the balance sheet just from 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 of 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 2002-2003 because if you remember a lot of people were still getting laid off in 2002-2003, 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 their 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 vacation, to buy fancy clothes or whatever and that drove the economy.
And in the next video, I'll actually talk about maybe why those housing prices go up or why they went up, in particular, during this housing boom? This one that we are definitely in the process of getting out of, see you in the next video.
Transcription by:
Scribe4you Transcription Services