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 practical terms, home equity is the appraised value of your home minus any outstanding mortgage and loan balances.
In most cases, home equity builds over time as you pay down mortgage balances or add value to your home. For many homeowners, home equity is their most valuable asset because it can be used to borrow home equity loans or lines of credit.
How do I build home equity?
Because 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. The easiest way to increase your home’s equity is by reducing the outstanding balance on your mortgage. Every month when you make your regular mortgage payment, you are paying down your mortgage balance and increasing your home equity. You can also make additional mortgage principal payments to build your equity even faster.
- When you make home improvements that increase your property’s value. Even if your mortgage principal balance remains the same, increasing the value of your home also increases your home equity. Just keep in mind that some home renovations add more value than others, research before starting a renovation project if your goal is to increase home equity.
- When the property value rises. Often (but not always), property values rise over time. This is called appreciation, and it can be another way for you to build your home equity. Because your property increasing in value depends on several factors, such as your location and the economy, there’s no way to tell how long you’ll have to stay in your home to expect a decent rise in value. However, looking at the historical price data of homes in your area may give you some insight as to whether home prices have been trending upward or downward.
- When you make a large down payment. Putting down a larger down payment can also increase the equity in your home. For example, if you put down 20 percent on your home instead of 10 percent, you’d have more equity. Doing so could also allow you to tap your home equity faster because lenders usually require you to have 20 percent equity in your home.
How do I calculate home equity?
To calculate the equity in your home, follow these steps:
- 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 home price estimator tools, but consider talking to a local real estate agent to get a more accurate measurement of your home’s market value. A lender may 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.
How does borrowing from 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 that you can later use for home equity 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. The bigger your down payment and the more you pay toward your mortgage, the greater chance you have of increasing your total equity.
Is it a good idea to use home equity?
Home equity loans may make sense for people who want to take advantage of low interest rates and long repayment terms. However, before you commit to using your home equity, consider both the benefits and the drawbacks.
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, such as:
- Lower interest rates. Your home is what makes your home equity loan or line of credit secure. These loans have lower interest rates than 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 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 your home. If housing values drop, you could also wind up owing more on your home than it’s worth. That can make it more difficult to sell your home if you need to.
- Misusing the money. It is best to 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.
Types of home equity loans
There are two types of home equity products, which differ in how you receive the cash and how you repay funds.
Home equity loans
A home equity loan is a second mortgage, meaning a debt that is secured by 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 monthly payments.
Home equity lines of credit (HELOCs)
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.
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 and sometimes an additional fee.
After the draw period, the remaining interest and the principal balance are due. Repayment periods tend to be from 10 to 20 years. The interest on a HELOC that is used for a substantial home improvement project may be tax-deductible.
Home equity loans vs. HELOCs
|Home equity loan||Home equity line of credit (HELOC)|
|Type of interest||Fixed||Variable|
|Repayment term||5 – 15 years||10 – 20 years|
|Type of loan||Secured||Secured|
|Best for||Debt consolidation, major renovation costs||Minor renovation costs over a number of years|
For those who are 62 and older, a reverse mortgage offers another way to tap into home equity. Using a reverse mortgage, homeowners who own their home outright or have a substantial amount of equity can withdraw a portion of that equity.
And unlike a HELOC or a home equity loan, the money withdrawn using a reverse mortgage does not have to be repaid in monthly installments. Instead, the lender pays the homeowner money each month, while the homeowner continues to live in the home. The loan must be repaid when the borrower dies, permanently moves out or sells the home.
How to find the best home equity loan
- A credit score of 620 or higher. A score of 700 and above will most likely qualify for the best rates.
- A maximum loan-to-value ratio (LTV) of 80 percent — or 20 percent equity in your home.
- A debt-to-income ratio no higher than 43 percent.
- A documented ability to repay your loan.
Home equity is a great financial tool that you can use to help 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 and shop around with multiple lenders before signing up.