What Is Home Equity and How Can You Use It to Your Advantage?

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Home equity is the portion of your home’s value that you own free and clear. You calculate it by subtracting the home’s value from the balance of any loans you have out against it. Equity typically builds gradually, and it makes up a significant percentage of American homeowners’ total wealth.

What Is Home Equity and How Does It Grow?

Home equity is the portion of the home’s value that you own. It grows over time based on several factors, with these contributing the most:

Down Payment

When you buy a home, the amount you put down creates instant equity. This assumes the home is worth at least the price you’re paying.

Mortgage Payments

With the most common types of mortgage loans, every payment you make pays off some of your loan principal, which is the amount you borrowed, and some of the interest due on the principal balance. This process is called mortgage amortization.

At first, nearly all of the payment goes toward interest because your principal balance is still large. As a result, equity builds slowly in the early years of the loan. But the balance shifts a little bit with each payment you make, so the longer you pay, the faster your equity grows.

Home Value

Real estate usually appreciates over the long term as a natural consequence of market shifts, and some home improvements can increase the home’s value as well.

Why Home Equity Is Important

While your home itself is an important physical asset, your equity in that home is a financial asset that provides numerous benefits.

It Protects You Against Foreclosure

Real estate values typically grow over the long term, but market downturns can reduce a home’s value to less than what the owner paid. This results in negative equity, where the owner owes more on the mortgage loan than the home is worth. That can make it difficult or impossible to sell the home if a financial setback prevents the homeowner from paying their mortgage. In turn, that can lead to foreclosure.

You Can Borrow Against It

Once you’ve built enough equity, some of it might be available for you to borrow by refinancing your mortgage or taking out a home equity loan or line of credit. You can use the money for just about any purpose.

It Helps You Build Wealth

Each dollar of equity you have equals a dollar of wealth. For many Americans, equity has more value than any other asset they hold — a median of $198,000, according to the U.S. Census Bureau.

Ways To Use Your Home Equity

You have several options for tapping into your equity with a loan designed specifically for that purpose.

Cash-Out Refinance Loan

A cash-out refinance loan is a new first mortgage for a larger amount than you owe on your current loan. The proceeds of the cash-out refi repay your current mortgage, and you take the rest in cash.

Home Equity Loan

A home equity loan gives you a lump sum payment against your equity. If you already have a loan on your home, the home equity loan is a second mortgage.

Most home-equity loans are fixed-rate loans, which means your rate and payment remain the same for the entire loan term. Terms range from five years to 30 years.

Home Equity Line of Credit

A home equity line of credit is a revolving credit line, and like a HELO, it’s a second mortgage if you already have a home loan.

A HELOC is similar to a credit card in that you can borrow against your credit limit, pay down your balance, and use the credit line again.

Unlike a credit card, a HELOC has two parts:

• Withdrawal period: Lasts about 10 years. During that time, you can withdraw funds against your limit
• Repayment period: This typically lasts 20 years.

HELOCS often have adjustable rates, but many lenders allow you to lock in a fixed rate on some or all of your outstanding balance.

Pros and Cons of Using Home Equity

Home equity is a valuable asset you’ll appreciate having if you need to borrow against it, but you should think carefully before taking out a loan.

Here are the pros and cons of using your equity.

Pros

• The rates are usually lower than rates on credit cards and other types of loans.
• With a HELOC, you have the flexibility of borrowing only what you need and making interest-only payments on your outstanding balance during the draw period.
• Depending on the loan type and how you use the money, your interest might be tax-deductible.

Cons

• All home-equity loans have closing costs — “no closing cost” loans simply include those costs in the interest rate.
• The additional debt you take on could leave you in a precarious position if you have a financial setback.
• Your home serves as collateral for the loan — if you default, the lender can foreclose.

How Much Equity Should You Have Before Borrowing?

When it comes to borrowing against your equity, the more equity you start with, the better. Most lenders require you to maintain at least 15% to 20% equity in your home after taking out a loan. This means your loan-to-value ratio should be between 80% to 85%, or lower. The exact requirements vary by lender and loan type.

Even if you can borrow more equity, you have a good reason not to. A dip in property values could leave you underwater and unable to sell if you need to.

How To Calculate Your Home Equity

Calculating your home equity is simple; just subtract your current loan balance from the value of your home.

Home Equity Calculation

Here’s what that looks like for a home worth $400,000 that has a $300,000 outstanding mortgage balance:

$400,000 – $300,000 = $100,000 in equity.

Tips To Grow Your Equity Faster

Your equity increases as your home’s value appreciates and you pay down your mortgage principal. But you can speed up growth.

• Make extra mortgage payments. Adding an extra principal-only payment to your regular mortgage payment each month increases your equity and speeds up repayment of your loan.
• Do a value-adding upgrade. Very few home improvements return 100% of your investment in added value, but the Journal of Light Construction lists three exceptions:
  • Garage door replacement: 193% of cost recouped
  • Entry door replacement with steel: 188.1% of cost recouped
  • Manufactured stone veneer: 153.2% of cost recouped
• Avoid unnecessary loans against your equity. In addition to using up more equity than you need to, you’ll pay loan fees that otherwise could go toward paying down your principal.

What Affects Your Home’s Value and Equity?

Equity is directly related to home value, so anything that affects your home’s value also affects how much equity you have. For example:

• Home condition and location: Location has the strongest impact on your home’s value, and your home’s condition in comparison to the conditions of similar homes plays a major role as well.
• Local real estate market trends: These can be seasonal fluctuations or more significant up and down trends that affect values over the longer term.
• Economic factors: Interest rates, inflation and other economic factors affect demand for homes. High demand drives home values up, and low demand causes values to fall.

Common Mistakes To Avoid With Home Equity

You can preserve your equity and maximize its growth by avoiding these common mistakes:

• Borrowing more equity than you need
• Borrowing for non-essential expenses, such as a vacation
• Not shopping around for the best rate and lowest loan fees

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