What Is Home Equity?
Home equity is the actual property’s current market value less any liens that are attached to that property. As more payments are made on the mortgage and market forces impact the property’s current value, the amount of equity in a house fluctuates over time. Home equity can represent more than the mortgage being paid off, it is an asset that homeowners can borrow against to meet important financial needs. This may include things such as paying off high-cost debt or college tuition.
The equity in your home can be a smart source of funds as the interest rate on home equity-based loans is sometimes lower than that on credit cards and personal loans. This is because the funds are secured by the equity. Also, if funds are used to improve the home, interest on such borrowing is generally tax deductible.
How Home Equity Works
If you acquire a mortgage loan for a portion or all of a home purchase, the lending institution has an interest in the home until the loan has been repaid. Home equity is simply the portion of a home’s current value that the owner possesses at any given time.
Equity in a house is initially acquired with the down payment that you make when you buy the property. After that, a homeowner’s equity continues to grow as payments are made because a specific portion of each payment is assigned to reduce the outstanding principal that you owe.
How to Calculate Your Home Equity
To calculate your home equity, first get an estimate of your home’s value by taking a look at what homes like yours in your neighborhood have recently sold for. Say that figure is $250,000. In addition, obtain the figure for the balance of your loan from your lender. For this example, let’s say that’s $125,000. Using those figures, here’s the calculation of your home equity:
- Equity = Value of home – loan balance
- Equity = $250,000 – $125,000
- Equity = $125,000
How to Borrow Against Home Equity
Home equity cannot be quickly converted into cash because the equity calculation is based on a current market value appraisal of your property. However, that appraisal is no guarantee that the property would sell at that price.
Even so, an owner can leverage their home equity as collateral in a variety of ways to secure low-cost funds for their financial needs:
Home Equity Loan
A home equity loan, or second mortgage, usually allows you to borrow a lump sum against your current home equity for a fixed rate over a fixed period.
Home Equity Line of Credit
A home equity line of credit (HELOC), works like a credit card, where you can continuously borrow up to an approved limit while paying off the balance. It is a revolving line of credit, usually with an adjustable interest rate, which allows you to borrow up to a certain amount over a period of time.
Fixed-Rate Home Equity Line of Credit
When a borrower converts any or all of the funds secured through a home equity line of credit to a fixed rate, they have what’s called a fixed-rate HELOC which will be paid off over a specific period of time. However, be sure to do your due diligence on this option because lenders may have different rules about how you can use it.
Cash-Out Refinance
A cash-out refinance refers to using your equity to get a new mortgage that’s larger than the amount owed on your existing mortgage. Because you pay off the existing mortgage and you may use the remaining money as needed for whatever you may choose. As with home equity loans and lines of credit, the funds are tax free because they’re viewed as debt by the IRS, not income.
How to Increase Your Home Equity
Now that you understand the benefits of home equity, you may want to focus on building it.
- To accrue equity instantly, make as large a down payment as possible on the home you’re buying.
- Be aware of the type of mortgage you’re getting. To build your equity consistently, avoid an interest-only loan as payments for that go toward interest alone.
- Make every mortgage payment timely and try to pay more than the minimum amount required.
- Stay in your home to take advantage of any appreciation in its value. The longer you’re in it, the more likely you’ll see some increase that adds to your equity stake.
- Consider making improvements to your home that add value to it. Do your research because not all changes a homeowner makes necessarily raise its value.
The Bottom Line
Home equity is the difference between the market value of your home, and how much you currently owe on your mortgage. So, if you were to sell your home, it’s the amount of money you would have after paying off your mortgage.Home equity is important because it determines how much money you will be left with after you sell your home and pay off your mortgage, and any sale related expenses and it’s also a large source of many peoples’ overall net worth. Home equity is also an asset; you can use it to finance other investments, or to make a down payment on a second home.
While there’s no one-size-fits-all answer, ideally, you should aim to have at least 20 percent equity in your home before you sell. And while your equity can fluctuate based on a variety of factors, the more equity you’ll build, and the more you’ll potentially profit if and when you do sell.