Understanding Home Equity: What It Is and How To Use It

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For many people, a home does double duty: It’s the place where you live, plus a powerful asset that can help you build your net worth.

As your home’s market value grows and you pay down the mortgage, you build “home equity,” which is the part of your home that you actually own.

If you’re a homeowner, it’s important to understand when and how to use the equity in your home.

Here’s what you need to know about home equity:

• What is home equity?
• How home equity works
• How to build home equity
• Why building equity in your home is important
• How to use the equity in your home
• How to borrow against home equity

What is home equity?

Home equity is the difference between what your home could sell for and the balance on your mortgage. In most cases, home equity builds over time as you pay down the home loan and wait for your home to gain value.

Calculating the equity in your home

You can calculate your home equity by subtracting your mortgage balance from the home’s market value.

Check your most recent billing statement to find your mortgage balance, or call the loan servicer to ask. To estimate your market value, you can look at recent, comparable home sales in your area or check third-party websites such as Zillow and Redfin.

How home equity works

When you take out a mortgage, lenders usually require a down payment. That money becomes your original equity stake, and you build more equity as you pay down the loan.

Homeowners with shorter loan terms build equity faster because they make larger payments over a shorter time frame.

Home equity is influenced by two factors — your mortgage balance and the home’s value — and changes over time. To get an idea of how it works, take a look at one example:

Say you take out a 30-year fixed-rate mortgage with an APR of 3% for a home worth $300,000. After making your down payment of 20%, your equity starts out at $60,000 and your mortgage balance starts out at $240,000.

After making on-time payments for five years, the mortgage balance decreases to $213,430. And because real estate prices have increased in your area, your home is now valued at $350,000.

You crunch the numbers to get your current home equity: $350,000 – $213,430 = $136,570.

How to build home equity

Home equity usually grows over time — which benefits you — and there are ways to move it along:

Make your mortgage payments

Every time you make a monthly mortgage payment, you gain a little more equity in the home. That’s because a portion of your monthly mortgage payment goes toward the principal balance on your home loan.

In the beginning, a smaller amount goes toward the principal and more goes toward interest.

This process, called amortization, means you usually build more equity toward the end of the loan term. Once the principal is paid off, you own the entire home.

Pay your mortgage down faster

Many lenders allow homeowners to make additional payments toward their principal. This can help you pay off your mortgage sooner, build equity faster, and save on interest.

Talk with your lender about this strategy and ask if the mortgage comes with prepayment penalties. Once you start making extra payments, tell your lender they should be applied to the principal only.

You don’t have to make big payments, either. Some homeowners choose to:

• Make one extra mortgage payment every year
• Add extra money to each monthly payment
• Use any one-time windfalls, such as a work bonus or inheritance, to pay down the principal

Wait for your property value to rise

Equity is also based on the market value of the home. Fortunately, home values tend to rise over time — even if you do nothing to the property.

Over the past 25 years, homes appreciated by 3.9% per year on average, according to mortgage data firm Black Knight.

Say you pay $300,000 for your home with $60,000 down. That gives you a $240,000 principal balance and $60,000 in equity right off the bat. After making on-time payments for one year, say your principal balance is now $234,000 — $6,000 less than when you started. Assuming the value of your home remains the same, you would have $66,000 in equity.

Using Black Knight’s average, if the home value increases 3.9%, or $11,700, over the course of the year, your equity would increase by the same amount. In this example, your home would now be worth $311,700, and you would have $77,135 in equity:

Make a big down payment

If you’ve not yet purchased a home, you can start off with more equity by making a larger down payment. Each extra dollar you pay up front increases your equity — and reduces the amount you need to finance.

Refinance to a shorter loan term

When you refinance from a 30-year loan to a 15- or 20-year loan, more of your payment goes toward the loan principal, so you build equity faster. In the case of a 30-year, $240,000 loan with a 3% fixed rate, you would build $5,435 in equity in the first year. That amount increases to $9,467 after the first year with a 20-year loan and $13,954 with a 15-year loan.

Get rid of mortgage insurance

This tip is a catch-22 in that you have to build equity to get rid of your mortgage insurance. Contact your lender once you reach 20% equity to request that the insurance be terminated — the lender might not do it automatically until you reach 22% equity.

Once you’re rid of the PMI premium, keep paying the same amount you paid before the PMI was discontinued. The extra payment will pay down the principal faster, increasing your equity as it does.

Renovate your home

Renovation projects — like adding a bedroom, remodeling the kitchen, and finishing the basement — could help boost your home’s market value. In turn, your home equity grows — as long as you don’t finance the work by borrowing against your house.

While you might not recoup all of the costs involved in a renovation project, homeowners get back 64% of the money they spend on average, according to Remodeling Magazine’s Cost vs. Value report.

Learn More: How Much It Costs to Renovate a House

Why building equity in your home is important

The more equity you build, the more protection you have against fluctuating property values leaving you underwater on your mortgage — that is, owing more on your mortgage than the home is worth.

While not a financial emergency in and of itself, being underwater can render you unable to sell your home. It also leaves you vulnerable to losing your home if you experience a financial setback like losing your job or incurring major medical expenses.

Even if you’re not underwater, low equity has a serious drawback: It makes the equity you do have inaccessible or expensive to access. Most lenders want you to have at least 20% equity to qualify for a home equity loan or cash-out refinance. Having less than 20% equity in your home may result in you paying higher interest rates or mortgage insurance to access the equity.

How to use the equity in your home

Your home equity makes up a part of your total net worth. You can tap into it by either selling the property or by borrowing money and using the home as collateral. Here are some of your options:

Buy a new home

If you’re ready to sell your home, you can use the proceeds as a down payment when you buy a new place. Making a large down payment can help shrink the size of your new monthly mortgage payments, since you’re borrowing less.

And if you put down at least 20% of the home’s value, you could also avoid private mortgage insurance.

Pay for home improvements

Using your equity to improve your home can be a smart way to invest in your property, since it can help boost the market value.

You don’t have to go for big projects, either. Common home improvement projects that can help preserve or increase your home’s resale price include:

• Making repairs
• Painting
• Deep cleaning
• Preventive maintenance
• Landscaping

Pay off high-interest debt

Home equity loans and home equity lines of credit tend to have lower interest rates than personal loans, credit cards, and other types of debt products.

Using this strategy, you tap your home equity at a low interest rate, pay off your higher-interest debts, and pay down the new loan over time — saving money in the process.

Use it for retirement

Home equity helps to secure your retirement even if you’re unable to pay off your mortgage before you retire. You can supplement your Social Security and retirement savings income with the equity in your home, using it to pay for medical expenses, home improvements, or whatever you wish.

Check out:

• Should You Get a Home Equity Loan for Debt Consolidation?
• Should You Refinance Your Mortgage to Pay Off Student Loans?

How to borrow against home equity

If you’re looking to take advantage of your home equity without selling your home, you have a few options.

Home equity loan

Best for: Paying for one-time expenses

A home equity loan is a second mortgage that uses the property as collateral. You receive the money in one lump sum upfront, then pay it back in installments over a specified number of years.

The maximum amount you can borrow with a home equity loan varies by lender, but it’s typically around 85% of the equity in your home. So, if you have $110,000 in equity, then you might be able to borrow up to $93,500.

Home equity line of credit (HELOC)

Best for: Homeowners who aren’t sure how much money they’ll need

A home equity line of credit is another type of second mortgage. Instead of getting money upfront, though, you get access to a line of credit.

You can borrow from the line of credit anytime during a “draw period,” which usually lasts around 10 years. If you pay off any of the balance during that time, the line of credit replenishes—much like a credit card.

The amount you can borrow on a HELOC varies, but it’s usually around 75% to 85% of the value of your home, minus your mortgage balance.

So, if your home is worth $290,000 and you owe $185,000 on the mortgage, then the most you can borrow is $61,500.

Cash-out refinance

Best for: Homeowners who want new loan terms

With a cash-out refinance, you take out a new mortgage that’s bigger than your current balance, use the proceeds to pay off the original loan, and pocket the difference.

Because you’re getting a new loan, your terms can be more suitable to your current situation.

For instance, you might change the loan term, get a lower interest rate, or shift from an adjustable-rate mortgage to one with a fixed rate.

Be sure to shop around for a great rate before you decide to refinance your mortgage. You can do this easily with Credible. It only takes a few minutes to see prequalified refinance rates from our partner lenders — best of all, it’s free and won’t affect your credit score.

Reverse mortgage

Best for: Homeowners who are at least 62 years old and have enough equity

A reverse mortgage is a special type of home loan that’s available to homeowners who are at least 62 years old. The amount you can borrow is based on how much equity you have in your home.

Once you receive the money, you’ll pay off any existing mortgage balance and use the remaining funds as you see fit. Instead of making monthly payments to the lender, the loan is repaid when you die, sell the home, or move out.

Aside from the age requirement, you’ll need to meet a few other requirements to be eligible. The home must be your principal residence, and you must stay on top of your property taxes, homeowners insurance, and routine maintenance.

Learn more:

• Reverse Mortgage Alternatives: 5 Options for Seniors
• Home Equity Loan or HELOC vs. Reverse Mortgage: How to Choose

About the author

Kim Porter

Kim Porter is an expert in credit, mortgages, student loans, and debt management. She has been featured in U.S. News & World Report, Reviewed.com, Bankrate, Credit Karma, and more.

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