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What is Home Equity?

What you'll learn: The definition of home equity plus how to calculate and use it to your advantage

EXPECTED READ TIME: 8 MINUTES

What is home equity?

 

As your homeowner repertoire grows, you’ll come across certain terms again and again. One of those words is equity. But what does home equity mean? And how does equity work?

In this comprehensive guide, we’ll start by covering the definition of equity in real estate. Then we’ll share how to calculate, build, and use home equity to your advantage.

Home equity definition

Equity in a house is the amount of your home you actually own. If you’re like most people, and took out a mortgage to pay for your home, your equity is based on how much of your mortgage is paid off.

Once you have enough equity, you have the option to access it for a variety of needs. Some of the most common uses for home equity include:

  • Home upgrades
  • Debt consolidation
  • Paying off student loans
  • Planning for future education
  • Emergency expenses

Calculating home equity

So, how is home equity calculated? Real estate equity is determined by subtracting what you owe on a property from its current market value. Here’s the simple formula:

Home Equity = (Current Market Value) - (Mortgage Balance)

For example, let’s assume you’ve been living in a home you purchased for $350,000. You do some research and understand the current market value to be approximately $425,000. In reviewing your outstanding debt on the home (including all loans, like a second mortgage or other home equity loan), you still owe $275,000. Your equity is calculated by taking the value ($425,000) minus the debt ($275,000). Your equity is the balance of $150,000.

To discover the current value of your home, you can use online tools and talk to a real estate agent to get a better understanding of your home’s value. If you decide to get a loan based on equity, the lender is likely to require a more formal process with an appraisal, which will confirm the actual current home value.

Building equity

Increasing your equity builds wealth and gives you more options if you want to sell your house or apply for a home equity loan or cash-out refinance. If your home equity isn’t  as high as you’d like it to be, how can you increase it? Here are three popular and effective options.

1. Pay down the principal

The first and most obvious is to make regular mortgage payments on time. Eventually, you will have paid enough principal to increase your home’s equity. Some people also choose to make extra payments each month or lump sums when they have extra funds available.

2. Make home improvements

One great way to up equity in your home is to upgrade areas of your home that may increase its value. Oftentimes, upgrades to the kitchen or bathrooms can increase a home’s value. Other ways to increase your home’s value include upgrading the home’s curb appeal through landscaping and keeping the home’s infrastructure, including the heating and cooling systems, in excellent condition.

3. Let it appreciate

As your home’s value increases, so does your home’s equity. This could be due to market forces such as a strong economy or even too few available houses on the market, which may cause prices to increase because of supply and demand.

How to use the equity in your home

Are you considering home improvements or need cash for an emergency or a way to consolidate high-interest debt? There are many ways you can leverage the equity in your home. Often the best way to use the equity in your home is to further increase the home’s value through upgrades. That may be a new kitchen or energy-efficient windows or appliances.

In any of those cases, a home equity loan or line of credit could be a great solution.

Get a lump sum with a home equity loan

Want all of the cash from your equity upfront? A home equity loan leverages the value you have in your home to provide the funds you need right away.

What is a home equity loan?

This type of loan uses your home as collateral to provide an interest rate that is typically lower than what you’d find for other mortgage types. It is a new loan separate from your original mortgage. 

How does a home equity loan work?

The process for getting a home equity loan is similar to that of other mortgage types. If approved, you receive the funds all at once. You’ll begin making payments right away on a schedule separate from your original mortgage.

What are the advantages of a home equity loan?

  • Typically has a lower interest rate that’s fixed for the life of the loan.
  • You receive an upfront lump sum of cash at closing.
  • Since the interest rate is fixed, you’ll know what your payments are for the life of the loan and can budget accordingly.
  • Won’t impact your first mortgage if you want to keep those terms.
  • Often offered for shorter terms, which can mean less interest paid over the life of the loan.

What are the disadvantages of a home equity loan?

  • Pay interest on the whole amount whether or not you use all the cash.
  • Adds a second mortgage to manage.
  • A shorter term can mean a higher monthly payment.
  • A home equity loan needs to be paid off before, or at the time of, a home’s sale.
  • If the housing market goes south, you may fall into a situation where you owe more on your home than it’s worth.
  • Like a traditional mortgage, there are closing fees and costs involved.
  • Depending on your use of the funds, the loan may not be tax-deductible. Always consult a tax advisor.

Home equity loans are popular for home improvements when working with a contractor and the total costs are known at the beginning of the project. They can also be a great way to reduce your interest rates on high-interest credit.

Access cash when you need it with a HELOC

An alternative option is a home equity line of credit (HELOC). Instead of obtaining your cash all at once, you leverage the equity from your home as you need it.

What is a HELOC?

Like a home equity loan, a HELOC uses your home as collateral to access your equity. But you can pull as little or as much cash as you need, when you need it, often for up to 10 years. You pay interest only on the funds you withdraw.

How does a HELOC work?

A HELOC has two periods: the draw period and the repayment period. During the draw period, you can access the cash whenever you want it, and the payments you make during this time are interest-only. When you reach the repayment period, you begin making regular monthly payments with principal and interest which is variable based on current market trends.

What are the advantages of a HELOC?

  • Take only as much money as you need, as you need it, during the draw period.
  • Pay interest only on the amount you draw.
  • Low introductory interest rate.
  • Acts like a credit card, but often with a higher balance and lower interest rate.
  • Usually has lower closing costs.

What are the disadvantages of a HELOC?

  • Variable interest rate may increase with the market.
  • Fluctuating monthly payments can make it hard to budget.
  • Revolving line of credit can be tempting to use for unintended purposes.

HELOCs offer tons of flexibility. You access the funds only as you need them and pay only for what you borrowed. You may prefer a HELOC if you have one or more ongoing projects and don’t know the total costs up front.

How to get a home equity loan or HELOC

Once you’ve determined your home’s equity and which option best suits your needs, you can apply for a home equity loan or HELOC. Typically, you’ll need the following to qualify:

  • Credit Score – A high credit score tells a lender you have a responsible history with debt. It’s typically required to have a score of at least 620. A higher score usually leads to a better interest rate.
  • Loan-to-Value (LTV) Ratio – LTV is a total of all mortgage debt divided by your home’s current appraised value. Lenders typically prefer an LTV under 80 to 85 percent.
  • Debt to Income (DTI) Ratio — This ratio compares your total debt to your income. You can calculate DTI by adding all your monthly debt payments, such as credit cards and car payments, and dividing the total by your gross (pre-tax) monthly income. Strive for 43 percent or lower.
  • Proof of Income – Be ready to provide your lender pay stubs, bank statements, and other necessary mortgage documents as documentation that you have resources to repay the loan

With ample equity and a favorable financial position, you’re well on your way to accessing the equity in your home. Just remember that leveraging equity is using your home as collateral for a new debt before contacting a home equity loan lender you trust.

 

 

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