What is Home Equity?
Home Equity: What it Is and How to Use It
Home equity is an asset that comes from a homeowner's interest in a home. To calculate equity, subtract any outstanding loan balances from the property’s market value. Home equity can increase over time if the property value increases or the loan balance is paid down.
Put another way, home equity is the portion of your property that you truly “own.” You certainly own your home, but if you borrowed money to buy the property, your lender also has an interest in the property until you pay off the loan.
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.
Home Equity Example
The easiest way to understand equity is to start with a home’s value and subtract the amount owed on any mortgages. Those mortgages might be purchase loans used to buy the house or second mortgages taken out later.
Assume you purchased a house for $200,000, made a 20 percent down payment, and got a loan to cover the remaining $160,000. In this example, your home equity interest is 20 percent of the home’s value: The home is worth $200,000, and you contributed $40,000 – or 20 percent of the purchase price. You own the home, but you really only "own" $40,000 worth of it.
Your lender doesn’t own any portion of the home – technically, you own everything – but the house is being used as collateral for your loan. Your lender secures their interest by getting a lien on the property.
Now, assume your home’s value doubles (unlikely, but it’ll keep the numbers simple). If it’s worth $400,000 and you still only owe $160,000, you have a 60 percent equity stake. You can calculate that by dividing the loan balance by the market value and subtracting the result from one (Google or any spreadsheet will calculate this if you use 1-(160000/400000), and then you’ll need to convert the decimal to a percentage). Your loan balance hasn’t changed, but your home equity increased.
As you can see, having more equity is a good thing. So how do you increase your equity?
Loan repayment: As you pay down your loan balance, your equity increases. Most home loans are standard amortizing loans with level monthly payments that go toward both your interest and principal. Over time, the amount that goes towards 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 non-amortizing loan, you don’t build equity in the same way. You may have to make extra payments to reduce the debt and build equity.
Price appreciation: You can also build equity without even trying. When your home gains value (because of improvement projects or a healthy real estate market), your equity increases.
For more details, read about building equity (and speeding the process).
Using Home Equity
Equity is an asset, so it’s a part of your total net worth. You can take income or lump-sum withdrawals out of your equity someday if you need to, or you can pass wealth on to your heirs. There are several ways to put that asset to work.
Buy your next home: You probably won’t live in the same house forever. If you move, you can sell your current home and put that money towards the purchase of your next home. If you still owe money on any mortgages, you won’t get to use all of the money from your buyer, but you’ll get to use your equity.
Borrow against the equity: You can also get cash and use it for just about anything using a home equity loan (also known as a second mortgage). Homeowners often use these funds for home improvement, to fund higher education, or for other purposes. However, it’s wise to put that money towards a long-term investment in your future – paying your current expenses is risky.
Fund retirement: You can also spend down your equity in your golden years using a reverse mortgage. Those loans provide income to retirees and don’t require monthly payments — the loan gets repaid when the homeowner leaves the house. However, these loans are complicated and can create problems for homeowners and heirs.
Home Equity Loans
Home equity loans are tempting because you have access to a large pool of money – often at relatively low interest rates. They’re also relatively easy to qualify for because the loans are secured by real estate. Before you take money out of your home, look closely at how these loans work and understand the risks.
Foreclosure: A major risk of using home equity is that your home serves as collateral for the loan. If you are unable to repay your loan, your lender can take the house in foreclosure and sell it to get their money back. That means you and your family will need to find other accommodations – probably at an inconvenient time – and your home probably won’t sell for top-dollar.
How to borrow: To get a home equity loan, you’ll apply with lenders, just like with any other loan. The lender will evaluate your home’s market value, and they’ll offer a maximum amount that you can borrow. In most cases, lenders limit loans to 80 percent or less of your home’s value (this is known as the loan to value ratio). That means your first (purchase) mortgage plus any additional loans you take on must be less than 80 percent of the appraised value. Lenders also evaluate your income and your credit history when approving loans.
Two Types of Home Equity Loans
A home equity loan is a lump-sum loan – you get all of the money at once, and you repay with a flat monthly payment over the coming years. Your interest rate is usually fixed.
A home equity line of credit (HELOC) allows you to pull funds out as needed. Similar to a credit card, you can borrow only what you need when you need it during the “draw period” (as long as your line of credit remains open). You’ll need to make modest payments on your debt during this time. After several years (10 years, for example), your draw period ends, and you’ll go into a repayment period where you more aggressively pay off all of that debt. HELOCs usually feature a variable interest rate.