What is Home Equity?

How Equity Works

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Upgrades can help increase the value of your property.. Moodboard Stock Photography Ltd. / Getty Images

Over your lifetime, home equity might become one of your most valuable assets. At some point, you might want to use that asset (with a second mortgage, for example), so it’s important to understand how it works.

What is Home Equity?

Home equity is an asset. It is the portion of your property value that you truly own. You might “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.

Your home equity is your interest in the property.

Equity Example

The easiest way to understand equity is to start with your home’s value and subtract the amount that you owe on any mortgages.

Assume you bought a house for $200,000, made a 20% down payment, and got a loan to cover the rest. In this example, your home equity interest is 20% of the home’s value: the home is worth $200,000 and you contributed $40,000 – or 20%. You own the home, but you really only "own" $40,000 worth of it.

Your lender doesn’t own the other portion – you own the house – 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% equity stake. Your loan balance hasn’t changed, but your home equity increased.

Building Equity

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 flat 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 other type of non-amortizing loan, you don’t build equity in the same way.

Price appreciation: you can also build equity without even trying. When your home gains value (because of improvements 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 spend it someday if you need to, or pass it on to your heirs. There are several ways to put that asset to work.

Buy your next home: you might not 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. You won’t get to take 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. Some homeowners have substantial equity in their homes and little saved for retirement.

Home Equity Loans

Home equity loans are tempting because you have access to a large pool of money – often at relatively low interest rates. Before you take money out of your home, look closely at how these loans work and understand the risks.

The main risk is that your home serves as collateral for a home equity 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 not at a convenient time – and your home probably won’t sell for top-dollar.

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% 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% of the appraised value.

Loans can come in two varieties.

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 generally fixed.

A home equity line of credit (HELOC) allows you to pull funds out as needed. Similar to a credit card, you can borrow 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.

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