Equity is the difference between the market value of your home and the amount you owe the lender who holds the mortgage. Put simply, it’s the amount of money you'd receive after paying off the mortgage if you were to sell the home.
Here's a simplified example: Say the fair market value of your home is $200,000 and you owe $150,000 on the mortgage. Your equity is, therefore, $50,000, assuming you sell the property for fair market value.
- In real estate, your equity in your property is the amount that you own, or what you would get after paying off your mortgage after selling.
- You can build equity by making a larger down payment, paying off your mortgage more quickly, and improving the house to increase its value.
- You can lose equity by increasing your loan amount, reducing the value of the house through disrepair or damage, or being exposed to disfavorable market changes.
- Building equity allows you to see more of a return on your investment when it's time to sell your house.
How Does Home Equity Work?
Home equity is your ownership of the house. To calculate your equity, take the home's current value (what it would fetch in the real estate market) and subtract any liens (such as what you owe on the mortgage). What's left over is your equity. It's what you would clear if you were to sell the home and repay your lender. And if you have a second mortgage, that counts against your equity, too. If your home is fully paid off, your equity would be the full value of the home—you'd have 100% ownership.
Your equity in the home is not the same as what you might clear from its sale, because you'll need to pay for the costs associated with selling it.
Selling a home doesn’t come for free. So, even if your equity stake is $50,000, as in the example above, it’s unlikely that you’d actually pocket that whole $50,000 once all is said and done.
What would you take home? That would be your equity minus the costs of selling the property. These costs might include your agent’s commissions (usually around 5% to 6% of your sales price), unpaid property taxes, and any closing costs not paid by the buyer.
If your home sells for $200,000, and your mortgage on the home is $150,000, your equity is $50,000—but you might owe a commission of $12,000 to your realtor. Your other closing costs, such as escrow fees, title charges, and tax prorations, add another estimated $3,000 in seller-paid costs. Your net equity is then reduced to $35,000: $50,000 minus the additional $16,000 in expenses.
How Is Home Equity Built?
As a homeowner, you can build home equity in two key ways: by increasing your home’s value or by reducing the amount you owe on the property. Here's how to do it.
Make Your Monthly Mortgage Payments
Every mortgage payment goes toward reducing your debt and increasing your equity. Adding in an extra payment or two per year can help, too.
Improve Your House
Upgrading your home and making smart improvements can also increase its value and therefore your equity stake. For example, you might spend $50,000 on remodeling your kitchen, which might increase the market value of the home by $30,000—assuming that you didn't take out a home equity loan to pay for the new kitchen.
Make a Larger Down Payment
The more you put down, the smaller your loan balance will be—meaning more home equity. You can experiment with the effect by using our mortgage calculator.
Sometimes, homes increase in value due to external factors, such as local market demand or growth in the community. When that happens, it also increases a homeowner’s equity stake in their property.
To see whether your home has increased in value due to outside influences, look at comparable sales in your neighborhood. If homes in your area are now selling for more, that means your home would likely sell for more, too.
As an example, you might have bought your home two years ago for $100,000 with a 20% down payment. If similar homes are now selling for $120,000, your equity in the home will have increased by $20,000 due to that rise.
How Do You Lose Equity?
You can also see your home equity fall. A decrease in local home values is one way it can happen. It can occur due to economic conditions in the area, changes to the neighborhood, deterioration or aging of homes in your area, and more. Basically, if homes are selling for less in your area, then your equity will fall as a result.
Here are some other ways you can lose equity:
- Increasing your loan amount (or the number of loans on your home): If you refinance your mortgage or take out a second mortgage or home equity loan, you'll most likely decrease your equity, too.
- Letting your home fall into disrepair: As your home’s condition declines, so does its value—and the equity you have in it.
- Market changes: Overall changes in your local real estate market and economy can also impact your home’s value and your equity.
If you’re worried that you may be losing the equity in your home, you might want to talk to a local real estate agent. They can pull local comparable sales to gauge your home’s fair market value and make recommendations for how you should move forward.
The Bottom Line
Equity is a powerful thing. Build more of it, and see a higher return on your investment when it's time to sell. Allow your home to lose equity, and you might lose money once you offload your property.
The moral of the story? If you own a home, keep tabs on your equity and where you stand. Take action early if you see things heading in the wrong direction, as that could help you prevent financial loss when you’re ready to sell.
Frequently Asked Questions (FAQs)
What is "sweat equity" in real estate?
"Sweat equity" isn't a special type of equity. The term is just another way to refer to building equity in your home through improvements. Typically, these are improvements you do yourself, hence the "sweat." For example, if you put in the time and energy to remodel the kitchen, then that "sweat equity" could increase the value of your home.
What is a "gift of equity" in real estate?
If you're selling a property to a family member, you may not care about capitalizing on every last dollar of equity you've built up over the years. If the sale price doesn't cover all of the equity you have in the property, then the leftover amount is a "gift of equity." It's essentially a discount on the property. If you think this might apply to your situation, you should check the current gift tax thresholds to learn about potential liabilities.