Home Equity: What It Is, How It Works, and How You Can Use It

What Is Home Equity?

Home equity is the difference between the amount you owe on a mortgage and what the home is worth. It's essentially what you own in a home. The amount of equity in a house can grow over time as you make payments and the property's value increases.

More technically, home equity is the property’s current market value minus any liens, such as a mortgage, that are attached to that property. 

Home equity is an asset that you can borrow against to meet important financial needs such as paying off high-cost debt or paying college tuition. Learn more about how home equity works, how to calculate it, and how you can use it.

How Home Equity Works

If all or part of your home is funded with a mortgage loan, the mortgage lender has an interest in the home until you pay off the loan. Home equity is the portion of a home's current value that you own outright.

You can have immediate equity in a house when you make a down payment. After that, the equity continues to grow as you make mortgage payments. A portion of each payment includes interest and an amount that reduces the outstanding principal that you still owe.

Another way equity can grow is from the appreciation of your property's value. If your property declines in value, you can lose equity. You can also lose equity if you take out a second mortgage using your equity as collateral.

How to Calculate Your Home Equity

Equity is the difference between what a home is worth and what's owed on a mortgage loan.

To calculate your home equity, first get an estimate of your home's value by researching the value of homes like yours in your neighborhood that have recently sold. Say that figure is $350,000. And assume the balance of your loan, which you can get from your mortgage lender, is $150,000. With those figures, here's how to calculate your home equity:

• Equity = Value of home - loan balance
• Equity = $350,000 - $150,000
• Equity = $200,000
  

Example of Home Equity

If you buy a home for $300,000 with a 20% down payment (covering the remaining $240,000 with a mortgage), you'll have equity of $60,000 in the house.

If the house's market value remains constant over the next two years, and $15,000 of mortgage payments are applied to the principal, you would have $75,000 in home equity at the end of the two years.

If the home's market value had also increased by $100,000 over those two years, you would then have $175,000 in home equity.

How to Borrow Against Home Equity

The interest rate on home equity-based borrowing is typically lower than that on credit cards and personal loans because the funds are secured by the equity. So the equity in your home can be a source of funds. The interest on borrowing with your home equity is generally tax deductible if funds are used to improve the home.

Unlike some investments, home equity cannot be quickly converted into cash. That's because the equity calculation is based on a current market value appraisal of your property. That appraisal is no guarantee that the property would sell at that price. 

However, you can leverage your home equity as collateral in a variety of ways to secure low-cost funds for your financial needs, including with home equity loans, home equity lines of credit, and cash-out refinance.

Home Equity Loan

A home equity loan, sometimes referred to as a second mortgage, usually allows you to borrow a lump sum against your current home equity for a fixed rate over a fixed period. Many home equity loans are used to finance large expenditures, such as home repairs or college tuition.

Home Equity Line of Credit

A home equity line of credit (HELOC) is a revolving line of credit, usually with an adjustable interest rate, which allows you to borrow up to a certain amount over a period of time. HELOCs work like credit cards, where you can continuously borrow up to an approved limit while paying off the balance.

Fixed-Rate Home Equity Line of Credit

When a borrower converts any or all of the funds secured through a home equity line of credit to a fixed rate, they have what's called a fixed-rate HELOC. The borrower will then pay off the fixed-rate amount over a specific period of time. Be sure to do your due diligence on this option because lenders may have different rules about how you can use it.

Cash-Out Refinance

A cash-out refinance refers to using your equity to get a new mortgage that's larger than the amount owed on your existing mortgage. Then, you pay off the existing mortgage and use the remaining money as needed. The money can be used in any way you choose. As with home equity loans and lines of credit, the funds are tax free because they're viewed as debt by the IRS, not income.

How to Use Home Equity

You can use your home equity and the funds you borrow to your financial benefit.

• Eliminate PMI: Cancel your private mortgage insurance when your equity reaches 20%. Usually, PMI is automatically canceled once your equity reaches 22%. However, you can request its removal at 20%.
• Consolidate debt: You can use a home equity loan or line of credit backed by equity to pay off credit card balances that carry high interest rates. Rates on home equity borrowing are usually much lower.
• Fund expenses: Use home equity loan funds to fund major purchases instead of using credit cards. That way, you can minimize higher-cost debt. For example, use the funds to pay for college tuition or a wedding instead of taking out a loan.

How to Increase Your Home Equity

Once you understand the benefits of home equity, you may want to focus on building it. To do that you could:

• Make as large a down payment as possible on the home you're buying to for immediate equity.
• Choose the right the mortgage type. For instance, to build your equity consistently, you may want to avoid an interest-only loan in which no principal is paid off until a single lump sum is required.
• Make every mortgage payment and try to pay more than the minimum amount required.
• Stay in your home to take advantage of any increase in its value. The longer you're in it, the more likely you'll see some appreciation. That adds to your equity stake.
• Consider making improvements to your home that add value to it. Not all changes you make will boost its value, so do your research.

Pros and Cons of Borrowing on Home Equity

Pros Explained

• Less stringent requirements: When you take out a home using your equity as collateral, you generally face less stringent requirements for getting approved. That's because the lender can relay on the equity to lower its risk. They can essentially foreclose on your home if you fail to make payments to recoup any lost funds.
• Lower interest rates: Home equity products typically have lower interest rates than unsecured loans and credit cards. This can save you money in the long-term.
• Tax deductible interest: Interest on home equity loans that you use for capital improvements is tax deductible, which can save you money.

Cons Explained

• Added debt: When you take out any loan, you increase your debt. This can increase the total amount you must pay each month, lowering your cash flow. Essentially you will have less money to put toward other expenses. Additional debt also lowers your credit score, which can potentially affect whether you get approved for a future loan and your interest rate on future loans.
• Potential fees: Fees may apply when you take out a home equity product. This will increase your total loan cost over what you pay in interest.
• Restricted use: In some cases, you must use funds from a home equity product for a specific purpose, such as renovating or remodeling your home.

The Bottom Line

Home equity refers to how much of the value of a home you control compared to that controlled by the lender of the mortgage loan. It consists of any down payment made, the portion of the mortgage payment made that pays down the principal and any appreciation of the value of the home.

The benefit of building equity in your home is both the asset that you build and the ability to borrow money against it.