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For many, home equity is their most valuable asset. In most cases, equity builds over time as you pay down your mortgage, your home’s value increases or you add value by making improvements. Here’s how equity works.
What is home equity?
Home equity is the portion of your home you’ve paid off — in other words, 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.
How to 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’re 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.
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 equity. Because your property increasing in value depends on several factors, such as location and the economy, there’s no way to tell how long you’ll have to stay in your home to see a rise in value. However, looking at the historical price data of homes in your area might give you some insight as to whether values have been trending upward or downward.
When you make a large down payment
Making a larger down payment when you buy the home instantly ups your equity — for example, putting down 20 percent versus 10 percent. Doing so could also allow you to tap your equity faster.
How to 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 might not be its value today. You can use online home price estimator tools, but consider talking to a local real estate agent or licensed appraiser to get a more accurate measurement of 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 to borrow home equity
Borrowing home equity could help you get cash for a renovation, consolidate debt or make progress on other financial goals. There are two main types of home equity products, which differ in how you receive the cash and how you repay funds:
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, 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.
With a HELOC, 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 years to 20 years. The interest on a HELOC that is used for a substantial home improvement project might be tax-deductible.
Home equity loans
A home equity loan is a second mortgage, meaning a debt secured by your property in addition to the first mortgage you used to buy it. 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 30 years. This option is ideal if you have a large, immediate expense. It also comes with the stability of predictable monthly payments.
|HELOC||Home equity loan|
|Type of interest||Variable rate||Fixed rate|
|Repayment term||10-20 years||5-30 years|
|Payout||Revolving credit||Lump sum|
|Type of loan||Secured||Secured|
Along with HELOCs and home equity loans, there are two other primary ways to borrow equity:
A cash-out refinance replaces your current mortgage with another, bigger loan. This loan includes the balance you owe on the existing mortgage and a portion of your home’s equity, withdrawn as cash. You can use these funds for any purpose. Unlike a HELOC or home equity loan, a cash-out refi might allow you to get a lower rate on your main mortgage, depending on market conditions, and shorten the term so you can repay it sooner.
For those who are 62 and older (or 55 and older with some products), a reverse mortgage offers another way to tap 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. Unlike a HELOC or a home equity loan, the money withdrawn using a reverse mortgage doesn’t have to be repaid in monthly installments. Instead, the lender pays you each month while you continues to live in the home. The loan must be repaid when the borrower dies, permanently moves out or sells the home.
Is it a good idea to use home equity?
Benefits of using home equity
- Lower interest rates: Your home is the collateral for a home equity loan or line of credit, so these types of products aren’t as risky as other forms of financing. Because of this, they 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 higher-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 to “buy, build or substantially improve” the home.
Drawbacks of using home equity
- 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 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 home 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’s best to use home equity to finance expenses that’ll 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.
How to qualify for the best home equity loan rates
Lenders have varying borrowing standards and rates, so you’ll want to shop around for the best deal. Most lenders are looking for a few basic minimum requirements:
- A credit score of 620 or higher (a score of 700 and above will qualify you for the best rates)
- A maximum loan-to-value (LTV) ratio of 80 percent (in other words, 20 percent equity in your home)
- A debt-to-income (DTI) ratio no higher than 43 percent
- A documented ability to repay your loan