Key takeaways
- Equity represents the paid-off portion of your home: the amount you own outright (as opposed to the mortgage lender)
- You largely build home equity via your down payment, then as you pay off your mortgage. Property value increases and home upgrades can increase your ownership stake too.
- You can tap into your equity and use it for various expenses, via home equity loans and home equity lines of credit (HELOCs)
- Despite competitive interest rates and tax advantages, home equity financing carries risks and extra costs.
You may feel your home belongs solely to you. But if you bought it with borrowed funds — aka a mortgage — it technically doesn’t: It also partly belongs to the lender who advanced you the funds. Your own stake in your home is expressed as your home equity — “equity” being synonymous with “ownership” in financial lingo.
More precisely, home equity equals the value of your economic interest in your residence. The difference between the size of your mortgage debt and the amount of the home you actually own: This is your equity, in a nutshell. It’s not a static amount. Your equity builds over time as you pay down your mortgage. Your home’s worth can also increase with a general rise in real estate values or if you make material improvements to it.
The equity in your home isn’t just a jewel in your estate crown: It can be a source of cash. Here’s how equity works, and how you can use it.
What is home equity?
Home equity is the portion of your home you own outright: your stake in the property as opposed to the lender’s. It equals the percentage of your home you originally paid for in cash (via your down payment) and have since paid off (in your monthly mortgage repayments). In mathematical terms, home equity is the appraised value of your home minus any outstanding mortgage and loan balances. As long as your home doesn’t depreciate in value and you continue to make on-time payments, equity will naturally build over time.
How to calculate home equity
To calculate the equity in your home, follow these steps:
- Get your home’s estimated current market value. What you paid for your home a few years ago or even last year might not be its value today. You can use online home price estimator tools, but consider talking to a local real estate agent or licensed appraiser to get a more accurate measurement of your home’s market value.
- Subtract your mortgage balance. Once you know the market value of your home, check your latest mortgage statement. Subtract the amount you still owe on your mortgage and any other debts secured by your home. The result is your home equity.
How to build home equity
Because home equity is the difference between your home’s current market value and your mortgage balance, your home equity can increase in a few circumstances.
When you make mortgage payments
The easiest way to increase your home’s equity is by reducing the outstanding balance on your mortgage. Every month when you make your regular mortgage payment, you’re paying down your mortgage balance and increasing your home equity. You can also make additional mortgage principal payments to build your equity even faster.
When you make home improvements that increase your property’s value
Even if your mortgage principal balance remains the same, increasing the value of your home also increases your home equity. Just keep in mind that some home renovations add more value than others. For instance, adding another bedroom — which has universal appeal and a variety of uses — is more certain to increase your home’s potential sale price than adding a niche amenity like a hot tub, which requires expensive maintenance — and which many people may not want, anyway.
When the property value rises
Often (but not always), property values rise over time. This is called appreciation, and it can be another way for you to build equity. Because your property increasing in value depends on several factors, such as location and the economy, there’s no way to tell how long you’ll have to stay in your home to see a significant rise in value. However, looking at the historical price data of homes in your area might give you some insight as to whether values have been trending upward or downward.
When you make a large down payment
Your initial equity stake in your new home reflects how much cash you actually put up to purchase it. So, making a larger down payment when you buy the home instantly ups your equity — for example, putting down 20 percent versus 10 percent. Doing so could also allow you to tap your equity faster.
How to leverage your home’s equity
Borrowing against your home equity could help you get cash for a renovation, consolidate debt or make progress on other financial goals. Here are some of the most common ways homeowners leverage their equity.
Consolidate high-interest debts
You can use your home equity loan or line of credit to pay off other debt, especially credit cards with high interest rates. You can often eliminate outstanding balances faster this way. Plus, mortgage debt is considered “good” debt — because it goes towards you acquiring a valuable asset — while credit card debt earns you nothing, and is more likely to drag down your credit score.
Cancel your private mortgage insurance (PMI)
If you take out a mortgage with a low down payment, you are likely to be on the hook for monthly private mortgage insurance (PMI) — an extra charge to reduce your lender’s risk if you default. With many loans, you can request the removal of your mortgage insurance once your equity stake hits 20 percent. Or you can refinance — a strategy that works well if your home has gained substantial value since you took out your original mortgage. (In fact, refinancing is the only way to get rid of mortgage insurance on recent FHA loans, unless you made a down payment of at least 10 percent.)
Pay for college tuition
Some homeowners take out a home equity loan instead of taking on student loans or parent loans to pay educational costs. Because the debt is secured, the terms are often more favorable than those other forms of financing, which are unsecured.
Finance home improvements
You can also use your equity to reinvest in your home — by using the funds to make substantial improvements, which will increase your home equity even more. Remodels and repairs are one of the most popular uses of home equity financing, in fact, because the interest is tax-deductible if the money goes towards upgrading the home. If you make energy-efficient upgrades, you will also be eligible for tax credits.
Ways to take equity out of your home
You can use the money for virtually anything, but how exactly do you tap into your home equity? There are two main types of home equity products, which differ in how you receive the cash and how you repay funds:
Home equity lines of credit (HELOCs)
A home equity line of credit, or HELOC, works like a credit card. You can withdraw as much as you want up to the credit limit during an initial draw period, usually up to 10 years. As you pay down the HELOC principal, the credit revolves and you can use it again. This gives you flexibility to get money as you need it.
With a HELOC, you can opt for interest-only payments or a combination of interest and principal payments. The latter helps you pay off the loan more quickly.
Most HELOCs come with variable rates, meaning your monthly payment can go up or down over the loan’s lifetime. Some lenders offer fixed-rate HELOCs, but these tend to have higher initial interest rates and sometimes an additional fee.
After the draw period, the remaining interest and the principal balance are due. Repayment periods tend to be from 10 years to 20 years. The interest on a HELOC that is used for a substantial home improvement project might be tax-deductible.
Home equity loans
A home equity loan is a second mortgage, meaning a debt secured by your property in addition to the first mortgage you used to buy it. When you get a home equity loan, your lender will pay out a single lump sum. Once you’ve received your loan, you start repaying it right away at a fixed interest rate. That means you’ll pay a set amount every month for the term of the loan, whether it’s five years or 30 years. This option is ideal if you have a large, immediate expense. It also comes with the stability of predictable monthly payments.
| Feature | HELOC | Home equity loan |
|---|---|---|
| Type of interest | Variable rate | Fixed rate |
| Repayment term | 10-20 years | 5-30 years |
| Payout | Revolving credit | Lump sum |
| Type of debt | Secured | Secured |
Along with HELOCs and home equity loans, there are two other primary ways to borrow equity:
Cash-out refinancing
A cash-out refinance replaces your current mortgage with another, bigger loan. This loan includes the balance you owe on the existing mortgage and a portion of your home’s equity, withdrawn as cash. You can use these funds for any purpose. Unlike a HELOC or home equity loan, a cash-out refi might allow you to get a lower rate on your main mortgage, depending on market conditions, and shorten the term so you can repay it sooner.
Reverse mortgages
For those who are 62 and older (or 55 and older with some products), a reverse mortgage offers another way to tap home equity. Unlike a HELOC or a home equity loan, the money withdrawn using a reverse mortgage doesn’t have to be repaid in monthly installments. Instead, the lender pays you each month while you continue to live in the home. The loan, plus interest, must be repaid when the borrower dies, permanently vacates or sells the home.
What to watch out for when borrowing against home equity
Borrowing against home equity has its benefits. Lower interest rates is a big one: Since your home is the collateral for a home equity loan or line of credit, they are considered less risky than other forms of financing, and so offer better rates than unsecured credit cards or personal loans. Then there are the tax benefits: If they itemize on their tax returns, homeowners can deduct the interest on home equity loans or lines of credit if the money is used to “buy, build or substantially improve” the home.
But there’s no such thing as a perfect financial vehicle, and there are some things to watch out for when tapping into your home equity.
Drawbacks of using home equity
- Borrowing costs: Some lenders charge additional fees for home equity loans or HELOCs; you often have to pay closing costs as you would on a mortgage. As you shop lenders, pay attention to the annual percentage rate (APR), which includes the interest rate plus other fees. If you roll these fees into your loan, you’ll likely pay a higher interest rate.
- Risk of losing your home: Home equity debt is secured by your home, so if you fail to make payments, your lender can foreclose. If home values drop, you could also wind up owing more on your home than it’s worth. That can make it more difficult to sell your home if you need to.
- Misusing the money: It’s best to use home equity to finance expenses that’ll serve as investments, like renovating a home to increase its value, paying for college, starting a business or consolidating high-interest debt. Stick to needs versus wants; otherwise, you’re perpetuating a cycle of living beyond your means.
- Potential rate changes: Most lines of credit and some loans have an adjustable rate, which means your interest could go up unexpectedly, increasing your payments. Especially with HELOCs: The burden can get really heavy when you reach your repayment period, and have both interest and principal to pay back.
How to qualify for the best home equity loan rates
Lenders have varying borrowing standards and rates, so you’ll want to shop around for the best deal. Most lenders are looking for a few basic minimum requirements:
- A credit score of 620 or higher (a score of 700 and above will qualify you for the best rates)
- A maximum loan-to-value (LTV) ratio of 80 percent (in other words, 20 percent equity in your home)
- A debt-to-income (DTI) ratio no higher than 43 percent
- A documented ability to repay your loan
Source: bankrate.com ~ By: Jeanne Lee ~ Image: Canva Pro