What Is Home Equity?

How Home Equity Works

Home equity is a calculation that shows you the difference between your home's value and what you owe on it. What you owe typically includes mortgages. These might be purchase loans that you used to buy the house, or second mortgages that you took out later.

Example of Home Equity

Suppose you bought a house for $200,000. You make a 20% down payment, and you obtain a a $160,000 mortgage to cover the rest. Your home equity is 20% of the value, or $40,000. You "own" only $40,000 worth of it, although you're the owner.

Now suppose that the housing market blooms, and your home’s value doubles to $400,000. You've paid your mortgage down to $140,000. So, your equity is $260,000, or 65%.

How Do You Build Home Equity?

You can take a few steps as a homeowner to increase your home equity.

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 home equity at a faster rate each year.

You wouldn't build home equity in the same way if you had an interest-only loan or another type of non-amortizing mortgage. 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 home equity without any effort on your part when the real estate market is healthy and growing.

Accelerated Payments

One popular method of building home equity sooner is making accelerated mortgage payments, such as bi-weekly payments. Doing so helps you pay off the mortgage and build equity faster.

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 you send your payment every two weeks: 365 days per year divided by 14 days equals 26. This pattern is the same as making 13 monthly payments.

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 half the monthly 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.

How To Use Home Equity

Home 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 now.

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." That 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.

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 any monthly payments. The loan is repaid when you leave the house.

But these loans are complicated and they can create problems for homeowners and heirs. Reverse mortgage requirements can be complex, so be wary of using one.

Types of Home Equity Loans

Home equity loans are tempting because 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'll fully understand the possible benefits and risks before you borrow money against your home's equity.

Lump Sum Loan

You can get all the money at once and repay it in flat monthly installments with a lump sum loan. The timeline could be as short as five years, or it could be as long as 15 years or even 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 high-interest debts, such as credit cards, or 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.

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 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

One risk of tapping into home equity is that your property secures the loan. Your lender could take your house in foreclosure and sell it to repay your debt if you're not able to repay the loan for some reason. The home would be sold quickly, so it probably wouldn't fetch the highest or best price. You and your family would 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. One safer move is to sock cash away for those treats or to 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 660 to obtain a home equity loan. A higher score is even better. You probably 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. That 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% home equity in your property, which translates to an LTV of at least 80%, but some lenders allow bigger loans.

Frequently Asked Questions (FAQs)