Home equity is a homeowner’s interest in a home. It can increase over time if the property value increases or you pay down the mortgage loan balance.
Learn more about home equity so that you can understand how it works should you become a homeowner.
What Is Home Equity?
Home equity is the portion of your property that you truly “own.” If you borrowed money to purchase a home, your lender has an interest in the property until you pay off the loan, although you’re still considered the homeowner.
Home equity is typically a homeowner’s most valuable asset. That asset can be used later in life, so it’s important to understand how it works and how to use it wisely.
How Home Equity Works
The easiest way to understand equity is to start with a home’s current value and subtract the amount owed on any mortgages or other liens. Those mortgages might be purchase loans used to buy the house or second mortgages that were taken out later.
Assume you purchased a house for $200,000, made a 20% down payment, and obtained a loan to cover the remaining $160,000. In this example, your home equity interest is 20% of the property’s value; the property is worth $200,000, and you contributed $40,000—or 20% of the purchase price. Although you’re considered the property owner, you only officially “own” $40,000 worth of it.
Your lender doesn’t own any portion of the property unless you’ve obtained a shared equity mortgage, which is relatively uncommon. Technically, you own everything, but the house is being used as collateral for your loan. Your lender secures its interest by getting a lien on the property.
Now, assume the housing market rises and your home’s value doubles. If the home is now worth $400,000, and you still only owe $160,000, then you have a 60% equity stake. Your loan balance remains the same, but the home’s value has increased, so your home equity increases, too.
How to Calculate Equity
You can calculate your equity stake by dividing the loan balance by the market value, then subtracting the result from one and converting the decimal to a percentage. In this example, the equation looks like this:
- 1 – (160,000 ÷ 400,000)
- 1 – 0.4
- 0.6, or 60%
How Do You Build Home Equity?
As you can see, it’s beneficial to build up more home equity. As a homeowner, there are steps you can take to increase your equity.
Loan repayment: As you pay down your loan balance, your equity increases. Most home loans are standard amortizing loans with equal monthly payments that go toward both your interest and principal. Over time, the amount that goes toward principal repayment increases—so you build equity at an increasing rate each year.
If you happen to have an interest-only loan or another type of nonamortizing loan, you don’t build equity in the same way. You may have to make extra payments to reduce the debt and increase equity.
Price appreciation: Your home equity grows in proportion to the price of your home. You can actively work to increase your home’s value through improvement projects. When the real estate market is healthy and growing, then house prices rise and you’ll build equity without any effort on your part.
Accelerated payments: An increasingly popular method of building home equity faster is a concept often referred to as “Accelerated Mortgage Payments.”
Most homeowners typically make mortgage payments on a monthly basis or 12 payments per year. Instead, if you split the monthly payment into two equal amounts and send your payment every two weeks, you will make 26 1/2 payments per year (365 days per year / 14 days = 26).
This, essentially, is equivalent to making 13 monthly payments. Using this approach will shave off a considerable amount of interest paid over the course of the loan, and will allow you to pay off the mortgage in a significantly shorter time frame, hence, building equity faster.
As an example, for a $100,000, 30-year conventional mortgage at 5% interest, making monthly payments for the length of the loan will result in $93,256 in interest paid over 30 years. If you were to make 1/2 of the payment every two weeks instead, the amount of interest paid would be reduced to $75,489 and the loan would be paid off in 25 years. You will save approximately $17,767 in interest and own your home free-and-clear five years sooner.
Before you decide to start making bi-weekly payments first check with your lender to make sure there are no restrictions regarding bi-weekly payments
How to Use Home Equity
Equity is an asset, so it makes up a portion of your total net worth. You can take partial or lump-sum withdrawals out of your equity if you need to, or you may pass all the wealth on to your heirs. If you decide to use some of your home equity, there are several ways to put that asset to work.
Sell your home: You probably won’t live in the same house forever. If and when you move, you can receive your equity in the home from the sale proceeds. If you still owe money on any mortgages, you won’t get to use all of the money from your buyer, but you’ll be able to use your equity to buy a new home or bolster your savings.
Borrow against the equity: You can also get cash and use it to fund just about anything with a home equity loan (also known as a second mortgage). This allows you to tap into your home equity while still living in your home. However, your goal as a homeowner should be to build equity, so it’s wise to put that borrowed money toward a long-term investment in your future.
Paying your current expenses with a home equity loan is risky because if you fall behind on payments and can’t catch up, you could lose your home.
Fund retirement: You can choose instead to spend down your equity in your golden years using a reverse mortgage. These loans provide income to retirees and don’t require monthly payments. The loan is repaid when the homeowner leaves the house. However, these loans are complicated, and they can create problems for homeowners and heirs.
It is important to note that you must be at least 62 years of age to take advantage of a reverse mortgage, and the home must be your primary residence.
Types of Home Equity Loans
Home equity loans are tempting because you have access to a large pool of money—often at fairly low interest rates. They’re also relatively easy to qualify for since the loans are secured by real estate. Before taking funds from your home equity, look closely at how these loans work so that you fully understand the possible benefits and risks.
A Home Equity Loan Is a Lump-Sum Loan
With a home equity loan, you get all of the money at once and repay in flat monthly installments throughout the life of the loan. This timeline could be as short as five years, or as long as 15 years or more. You’ll have to pay interest on the full amount, but these types of loans may still be a good choice when you’re considering a large, one-time cash outlay.
Examples of this include paying for a full rehab of your home, consolidating higher-interest debts (such as credit card debt), or buying a vacation getaway. Your interest rate is usually fixed with a home equity loan, so there will be no surprising rate hikes later, but note that you’ll likely have to pay closing costs and fees on your loan.
Home Equity Lines of Credit (HELOCs) Provide Flexibility
A HELOC allows you to pull funds out as necessary, and you pay interest only on what you borrow. Similar to a credit card, you can withdraw the amount you need during the “draw period” (as long as your line of credit remains open).
For this reason, HELOCs are often useful for expenditures that can be spread out over multiple years, like minor home renovations, college tuition payments, and assisting family members who may temporarily be down on their luck.
During the draw period, you have to make modest payments on your debt. After a certain number of years (10 years, for example), the draw period ends, and you enter a repayment period in which you pay off all of the debt more aggressively. The repayment period could include a hefty balloon payment at the end.
HELOCs usually feature a variable interest rate, too, which means you could end up having to pay back much more than you budgeted for over the life of the loan, which could be as long as 20 years.
Risks of Borrowing Against Home Equity
A risk of tapping home equity is that your home then serves as the loan collateral. If you’re unable to repay for any reason, your lender can take your house in foreclosure and sell the property to repay your debt.
In this unfortunate scenario, the home will be sold quickly, which means it probably won’t fetch as high of a price as possible. Adding to your financial concerns, you and your family will need to find another place to live.
For this reason, it’s smart to avoid the temptation to use your windfall to splurge on exotic vacations, designer clothes, big-screen TVs, luxury cars, or anything else that doesn’t add value to your home. A safer move is to sock away cash for those treats or spread out the cost using a credit card with a 0% intro APR offer.
How to Qualify for a Home Equity Loan
Before you start shopping around for lenders and loan terms, check your credit score. To obtain a home equity loan, you’ll typically need a credit score of at least 680. A higher credit score is better. If you can’t meet credit score minimums, you probably won’t be able to qualify for either type of loan until you repair your credit score.
You must demonstrate your ability to repay the loan to the lender. This means providing your credit history and documentation of your household income, expenses and debts, and any other amounts you’re obliged to pay.
Your property’s loan-to-value or LTV ratio is another factor lenders look at when determining whether you qualify for a home equity loan or HELOC. It’s probably best to keep at least 20% equity in your property, which translates to a minimum LTV of 80%, but some lenders allow bigger loans.
- Home equity is a homeowner’s interest in a home.
- It has the potential to increase over time increase if the property value increases or you pay down the mortgage loan balance.
- The easiest way to understand equity is to start with a home’s current value and subtract the amount owed on any mortgages or other liens.
- As a homeowner, there are ways you can work toward building up your home equity.
- You can borrow money against your home equity, but it can become risky since your home serves as the loan collateral should you not be able to pack it back for any reason.