What Is Home Equity?
Home equity represents the difference between your property’s current market value and any outstanding liens, such as a mortgage. Essentially, home equity is the portion of your home that you truly own. This equity can grow over time as you make regular payments towards your mortgage and as the property value appreciates.
More technically, home equity is determined by subtracting any existing liens from the market value of your home. Home equity is a valuable asset you can borrow against to meet important financial needs, like paying off high-cost debt or covering college tuition.
Key Takeaways
- Home equity is calculated as the current market value of your home minus any liens such as a mortgage.
- You can leverage your home equity by using it as collateral for a home equity loan or a home equity line of credit.
- Immediate equity can be realized when you make a down payment of 20% or more on a new home.
- Home equity can fluctuate depending on changes in the market value of your property.
How Home Equity Works
If a mortgage loan funds part or all of your home, the mortgage lender retains a stake in the home until the loan is fully paid off. Home equity is the portion of the home’s current value you own outright.
Immediate equity can be gained through a substantial down payment. Over time, equity increases as you make mortgage payments, each reducing the ending principal balance of the loan. Your property’s appreciation also boosts your home equity, while depreciation and secondary mortgages might reduce it.
How to Calculate Your Home Equity
To calculate your home equity, estimate your property’s market value by reviewing comparable homes in your neighborhood. Subtract the remaining mortgage balance from this estimate to arrive at your home equity.
Example Calculation:
- Assume an estimated property value of $350,000 and a remaining mortgage balance of $150,000.
- Equity = Property Value - Mortgage Balance
- Equity = $350,000 - $150,000 = $200,000
Inspiring Example
Imagine buying a home for $300,000 with a 20% down payment, resulting in an initial equity of $60,000. If over two years, $15,000 of your mortgage payments goes towards the principal and the home’s value increases by $100,000, your total home equity would then be $175,000.
Home equity is an asset and is part of your net worth, though not readily convertible to cash.
Leveraging Home Equity
Borrowing against your home equity can be more cost-effective than other loan types, often providing access to lower interest rates. Interest on home equity-funded borrowing is typically tax-deductible if the funds are used for property improvements.
Home Equity Loan
A home equity loan lets you borrow a lump sum at a fixed interest rate, often used for significant expenses like home renovations or college tuition.
Home Equity Line of Credit (HELOC)
A HELOC provides a revolving line of credit with an adjustable interest rate, enabling continuous borrowing up to a preset limit and repayment flexibility.
Fixed-Rate HELOC
With a fixed-rate HELOC, part or all of the borrowed funds are converted into a fixed-rate loan, offering predictable, scheduled repayments.
Cash-Out Refinance
Through cash-out refinancing, secure a new mortgage larger than your current one, pay off the existing mortgage, and use the extra funds for various financial needs. These funds remain tax-free as they are considered debt, not income.
Using Home Equity
Utilize home equity in several strategic ways, including:
- Canceling PMI: When your equity reaches 20%, request the removal of private mortgage insurance to reduce your monthly expenses.
- Debt consolidation: Use equity to consolidate high-interest debt like credit card balances into one manageable payment with a lower interest rate.
- Major purchases: Utilize home equity funds for major expenses such as college tuition or home repairs, reducing dependency on higher-interest loans.
Growing Your Home Equity
To build home equity faster:
- Make a large down payment on your property.
- Opt for mortgage types that pay down the principal consistently.
- Make regular and additional mortgage payments.
- Stay in your home longer to benefit from value appreciation.
- Invest in home improvements that add value.
Pros and Cons of Borrowing Against Home Equity
Pros
- Less stringent requirements: Approval is typically easier due to the collateral provided by your home equity.
- Lower interest rates: Interest rates on home equity products are generally lower than those for unsecured loans and credit cards.
- Tax-deductible interest: Interest on loans used for home improvements may be tax-deductible.
Cons
- Added debt: Increasing your debt burden impacts your monthly cash flow and credit score.
- Potential fees: Borrowing costs may include fees, adding to the loan’s total expense.
- Restricted use: Some loans may require you to use funds for specific purposes, like home renovations.
What Is a Home Equity Loan?
A home equity loan provides a lump sum that you repay in fixed-rate, monthly payments. It is often called a second mortgage.
Steps to Secure a Home Equity Loan
To get a home equity loan:
- Contact a lender.
- Get a property appraisal.
- Meet credit and debt-to-income requirements.
- Upon approval, receive a lump sum which you repay in monthly installments.
HELOC: A Flexible Option
A HELOC acts like a credit card based on your home’s equity, allowing you to borrow, repay, and then borrow again in the draw period, followed by the repayment period.
Determining Your Home Equity
To determine your home equity:
- Assess your home’s market value.
- Subtract your current mortgage balance.
Conclusion: Building Wealth Through Home Equity
Building home equity enhances your net worth and enables borrowing for important financial needs. Use this valuable asset wisely to secure your financial future.
Related Terms: mortgage, home equity loan, HELOC, refinancing, property value, PMI, debt consolidation, financial planning
References
- Consumer Financial Protection Bureau. “What Is a Home Equity Loan?”
- Freddie Mac. “Understanding Your Home’s Equity”.
- Internal Revenue Service. “Publication 936 (2021), Home Mortgage Interest Deduction”.
- Federal Trade Commission. “Home Equity Loans and Home Equity Lines of Credit”.
- National Credit Union Administration. “Home Equity Loans and Lines of Credit”.
- Bank of America. “Fixed-Rate Loan Option”.
- U.S. Department of Veterans Affairs. “Cash-Out Refinance Loan”.
- Experian. “Do I Have to Pay Taxes on a Cash-Out Refinance?”
- Office of the Comptroller of the Currency. “At What Point Can I Removed the PMI?”
- MyFICO. “What’s in My FICO Score?”
