Home equity is the portion of your home that you’ve paid off — your stake in the property, as opposed to the lender’s. In dollars, it is the estimated market value of your home minus the balance remaining to be paid on your mortgage. For many homeowners, home equity is their most valuable asset.
How does home equity work?
Whether you’re looking to free up cash for a home renovation or find ways to consolidate debt, borrowing against the value of your home could be a good option. While you pay off your home, you build equity — the value of your home, minus your mortgage debt — which you can later use for loans or home equity lines of credit (HELOCs).
Because you can use equity for loans or tap into it when selling your home, it’s a great financial tool. And the bigger your down payment and the more you pay toward your mortgage, the greater chance you have at increasing your total equity.
How do you build home equity?
Home equity is the difference between your home’s current market value and your mortgage balance. Your home equity can increase in a few circumstances:
- When you make mortgage payments.
- When the property value rises.
- When you make certain improvements to the property.
Here’s how to calculate how much home equity you have:
- Get your home’s estimated current market value. What you paid for your home a few years ago or even last year may not be its value today. You can use online real estate tools, but consider talking to a local real estate agent. A lender will order a professional property appraisal to determine your home’s market value.
- Subtract your mortgage balance. Once you know the market value of your home, subtract the amount you still owe on your mortgage and any other debts secured by your home. The result is your home equity.
Two types of home equity loans
There are two types of home equity products, which differ in how you receive the cash:
- Home equity loan: A second mortgage, paid in a lump sum and repaid in monthly installments.
- Home equity line of credit (HELOC): Similar to a credit card, a line of credit with a limit for what you can borrow.
Home equity loans
A home equity loan is a second mortgage, meaning a debt that is secured on your property. When you get a home equity loan, your lender will pay out a single lump sum. Once you’ve received your loan, you start repaying it right away at a fixed interest rate. That means you’ll pay a set amount every month for the term of the loan, whether it’s five years or 15 years. This option is ideal if you have a large, immediate expense. It also comes with the stability of predictable second-mortgage payments.
Home equity lines of credit
A home equity line of credit, or HELOC, works like a credit card. You can withdraw as much as you want up to the credit limit during an initial “draw” period that is usually up to 10 years. As you pay down the HELOC principal, the credit revolves and you can use it again. This gives you flexibility to get money as you need it.
Use Bankrate’s home equity loan rates table to see current rates.
You can opt for interest-only payments, or a combination of interest and principal payments. The latter helps you pay off the loan more quickly.
Most HELOCs come with variable rates, meaning your monthly payment can go up or down over the loan’s lifetime. Some lenders offer fixed-rate HELOCs, but these tend to have higher initial interest rates.
After the draw period, the remaining interest and the principal balance are due and the interest rate becomes fixed. Repayment periods tend to be from 10 to 20 years. Using a HELOC for a substantial home improvement project may be tax-deductible.
|Home equity loan||Home equity line of credit (HELOC)|
|Type of interest||Fixed rate||Variable rate|
|Repayment term||5 – 10 years||10 – 20 years|
|Payout||Lump sum||Revolving credit|
|Type of loan||Secured||Secured|
|Best for||Debt consolidation, major renovation costs||Minor renovation costs over a number of years|
How to qualify for a home equity loan
To qualify for a home equity loan, here are some minimum requirements:
- Your credit score is 620 or higher — 700 and above will most likely qualify for the best rates.
- You have a maximum loan-to-value ratio, or LTV, of 80 percent — or 20 percent equity in your home.
- Your debt-to-income ratio is 43 percent to 50 percent.
- You have a documented ability to repay your loan.
- An approximate figure for how much you want to borrow.
Lenders have varying borrowing standards and rates for home equity products, so you’ll want to shop around for the best deal.
If your credit score is lower than 620, it may be difficult to qualify for a home equity loan. Lenders will check your financial documentation, credit score, debt-to-income ratio, income and employment to ensure you can repay the loan. It’s best to have all this available beforehand.
It helps to know how much you want to borrow and what you’re using the money for. Home equity loans are long-term loans that take years to repay so don’t borrow more than you need, only using it for major financial reasons.
Benefits of using home equity
Home equity can be a useful tool when you need a large sum for home improvement, debt consolidation or any other purpose. Home equity loans and HELOCs have their benefits, like:
- Lower interest rates. Your home is what makes your home equity loan or line of credit secure. These instruments have lower interest rates than other types of unsecured debt, such as credit cards or personal loans. This can help you save on interest payments and improve monthly cash flow if you need to lower high-interest debt.
- Tax benefits. The 2017 Tax Cuts and Jobs Act allows homeowners to deduct the mortgage interest on home equity loans or lines of credit if the money is used for capital improvements, such as to “buy, build or substantially improve” the home that secures the loan.
Drawbacks of using home equity
Using home equity doesn’t work for everyone in every situation. Drawbacks include:
- Borrowing costs. Some lenders charge fees for home equity loans or HELOCs. As you shop lenders, pay attention to the annual percentage rate (APR), which includes the interest rate plus other loan fees. If you roll these fees into your loan, you’ll likely pay a higher interest rate.
- Risk of losing your home. Home equity debt is secured by your home, so if you fail to make payments, your lender can foreclose on it. If housing values plummet, you could wind up underwater, meaning you owe more on your home than it’s worth. Your credit and finances could take a major hit, too.
- Misusing the money. You should only use home equity to finance expenses that will pay you back, like renovating a home to increase its value, paying for college, starting a business or consolidating high-interest debt. Stick to needs versus wants; otherwise, you’re perpetuating a cycle of living beyond your means.
Personal loans as an alternative to home equity loans
If you don’t own a home or you have other needs you want to use the money for, you may consider getting a personal loan instead.
Personal loans are available through online lenders, banks and credit unions. The best personal loan lenders have competitive interest rates, low to no fees and flexible repayment terms. You can use a personal loan for anything, like consolidating credit card debt, paying for a wedding, moving or other personal reasons.
The best way to qualify for a personal loan is to have a great credit score with a steady job and reliable income. The higher your credit score, the more likely you are to qualify for a low-interest loan. The lower your credit score, the higher your interest rate, which means the higher your overall loan repayment.
Having a low credit score may disqualify you from getting approved for a loan. If that’s you, consider enlisting a cosigner, who would be equally responsible for the debt.
The bottom line
Home equity is the difference between how much a home is worth and any debts against it, such as a primary mortgage. Home equity loans and HELOCs are types of second mortgages that let you use your home’s value as collateral to pull out cash. Home equity loans or lines of credit can help you pay for big expenses like a home renovation, high-interest debt consolidation or college expenses. If you need a large amount of cash, you may want to consider borrowing some of the equity you have built up in your home. But you should do so with care.