Home equity is the portion of your property that you truly “own.” Your lender has an interest in the property until you pay off your mortgage, although you’re still considered to be the homeowner.
Home equity is often an owner's greatest asset. It can be used later in life, so it pays to know how it works and how to use it wisely.
What Is Home Equity?
Home equity starts with your home’s current value. Now subtract the amounts owed on any mortgages or other liens against it. These liens might be purchase loans that you used to buy the house, or second mortgages that were taken out later. The difference is your home equity.
Your lender doesn’t own any portion of the property unless you've obtained a shared equity mortgage, which isn't common. You own the house, but it's being used as collateral for your loan. Your lender secures its interest by getting a lien against it.
How Home Equity Works
Assume you purchase a house for $200,000. You make a 20% down payment, and you obtain a mortgage loan to cover the $160,000 balance. Your home equity interest is 20% of value: The property is worth $200,000, and you contributed $40,000, or 20% of the purchase price. You "own" only $40,000 worth of it, although you're the owner.
Now assume that the housing market blooms and your home’s value doubles. You'd have a 60% equity stake if the home is now worth $400,000, and you still owe only $160,000. Your loan balance remains the same, but the home's value has increased, so your home equity goes up, too.
How to Calculate Equity
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. The equation would look like this:
- 160,000 ÷ 400,000 = 0.4
- 1 - 0.4 = 0.6
- 0.6 = 60%
How Do You Build Home Equity?
You can take a few steps as a homeowner to increase your equity in your home.
Pay Off the Loan(s)
Your equity increases as you pay down your loan balances. Most home loans are standard amortizing loans with equal monthly payments that go toward both your interest and principal. The amount that goes toward principal repayment increases over time, so you build equity at a faster rate each year. Use our loan amortization calculator to figure your payoff date.
You wouldn't build equity in the same way if you had an interest-only loan or another type of non-amortizing loan. You may have to make extra payments to reduce the debt and increase your equity in this case.
Your home equity grows as the value of your home rises. You can actively work to increase your home's value through improvement projects. House prices rise and you'll build equity without any effort on your part when the real estate market is healthy and growing.
A popular method of building home equity faster is a concept often referred to as "accelerated mortgage payments."
Most homeowners make mortgage payments on a monthly basis, or 12 payments each year. You'll make 26 payments per year if you split your monthly payment into two equal amounts instead and send your payment every two weeks: 365 days per year divided by 14 days equals 26.
This is the same as making 13 monthly payments. Using this approach will shave off a good bit of interest over the life of the loan. It will allow you to pay off the mortgage in a much shorter time frame and build equity faster.
Making monthly payments over the life of the loan would result in $93,256 in interest paid over 30 years if you have a $100,000, 30-year conventional mortgage at 5% interest. The amount of interest paid would be reduced to $75,489 and the loan would be paid off in 25 years if you were to make 1/2 the payment every two weeks instead.
You would save about $17,767 in interest and you would own your home free and clear five years sooner.
Check with your lender to make sure there are no rules against making biweekly payments before you decide to take this approach.
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 can save it up and pass all the wealth on to your heirs.
There are a few ways you can put your asset to work for you if you decide to use some of your home equity.
Sell Your Home
You can take your equity in the home from the sale proceeds if and when you decide to move. You won’t get to use all the money from your buyer if you still owe on a balance on any mortgages, but you’ll be able to use your equity to buy a new home or to bolster your savings.
Borrow Against the Equity
You can 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 you're still living there. But 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 rather than just spend it.
Paying your current expenses with a home equity loan is risky because you could lose your home if you fall behind on payments and can't catch up.
Fund Your Retirement
You can spend down your equity in your golden years with a reverse mortgage. These loans provide income to retirees. You don't have to make monthly payments. The loan is repaid when you leave the house. But these loans are complicated. They can create problems for homeowners and heirs.
Reverse mortgage requirements can be complex. To start, you must be at least 62 years old, and the home must be your primary residence.
Types of Home Equity Loans
Home equity loans are tempting because you they can give you access to a large pool of money, often at fairly low interest rates. They’re also pretty easy to qualify for because the loans are secured by the real estate. Look closely at how these loans work so you fully understand the possible benefits and risks before you borrow money against your home's equity.
It's a Lump-Sum Loan
You can get all the money at once and repay it in flat monthly installments. The timeline could be as short as five years, or it could be as long as 15 years or more.
You'll pay interest on the full amount, but these types of loans may still be a good choice if you're thinking about a large, one-time cash outlay. You might want to consolidate higher-interest debts such as credit cards or buy a vacation getaway. Your interest rate is often fixed with this type of loan, so there won't be any surprise hikes later, but you'll likely have to pay closing costs and fees to take out the loan.
Home Equity Lines of Credit (HELOCs) Provide Flexibility
A HELOC allows you to pull funds out as you need them. 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.
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 be down on their luck.
You must make modest payments on your debt during the draw period, which ends after a certain number of years, such as 10 or 12. You then enter a repayment period during which you pay off all the debt. The repayment period could include a hefty balloon payment at the end.
HELOCs often feature a variable interest rate, too, so you could end up having to pay back much more than you budgeted for over the life of the loan.
Risks of Borrowing Against Home Equity
A risk of tapping into home equity is that your home secures the loan. Your lender can take your house in foreclosure if you're not able to repay the loan for some reason, and sell it to repay your debt.
The home would be sold quickly, so it probably won't fetch the highest or best price. You and your family will have to find another place to live, adding to your financial concerns.
It's smart to avoid using your windfall to splurge on designer clothes, big-screen TVs, luxury cars, or anything that doesn't add value to your home. A safer move is to sock away cash for those treats, or spread out the cost by using a credit card with a 0% intro APR offer.
How to Qualify for a Home Equity Loan
Check your credit score before you start shopping around for lenders and loan terms. You'll most likely need a credit score of at least 680 to obtain a home equity loan. A higher score is better. You most likely won't be able to qualify for either type of loan until you repair your credit score if you can't meet the minimum requirement.
You must show that you're able to repay the loan. This means providing your credit history and your household income, expenses, debts, and any other amounts you're obliged to pay.
Your property's loan-to-value (LTV) ratio is another factor that lenders look at when qualifying you for a home equity loan or HELOC. It's often best to keep at least 20% equity in your property, which translates to an LTV of at least 80%, but some lenders allow bigger loans.
- Home equity is an owner's interest in a home.
- It has the potential to increase over time if property values rise, or as you pay down your mortgage loan balance.
- You can calculate your equity by starting with your home’s current value, then subtracting the amounts you owe on any mortgages or other liens.
- There are ways you can work toward building up equity in your home.
- You can borrow money against your home's equity, but this can be risky because your home secures the loan.