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If you’re like the average person, your house isn’t just a place to lounge around in pajama pants.
It’s also your most valuable asset – an item to leverage when building wealth and accomplishing your goals. But in order to use your home equity, you have to build it first.
What is Home Equity?
Your home equity is the difference between what you owe on any liens against the property and the current market value of your home.
For instance, if you own your home, then you have 100% equity. But if you owe $100,000 on a house worth $200,000, then you own $100,000 in equity.
Home equity provides a line to a source of low-interest cash that you can use for several purposes.
Some homeowners tap their equity to pay for renovations, fund college expenses, or kickstart their retirement savings.
While you have to repay your debt, you’ll ultimately pay less in interest than taking out a credit card or personal loan.
How Does Home Equity Work?
Building home equity takes time and money. As you pay down your mortgage, your equity increases. You also “earn” more equity if the market value of your house rises.
Conversely, if the market value of your house falls – such as happened during the 2008 housing crash – your equity will fall, too. If you’re still paying a mortgage, you can even owe more than your home is worth.
Let’s break down how equity works with an example.
Example of How Home Equity Works
Let’s say that you take out a VA mortgage for 100% of your home’s value, or $200,000. In the beginning, you own 0% equity in your home.
Over the next ten years, you pay your loan down by $100,000, with $100,000 remaining on the mortgage.
At this point, you own $100,000 in home equity that you can borrow against with a second mortgage, home equity loan, or HELOC.
Now let’s say that the housing market booms. Suddenly, your home’s value soars to $350,000. Though you’ve only paid $100,000 on your mortgage so far, you now own $250,000 in equity.
But just days later, the market bottoms out, and your home’s value drops to $100,000. Despite having paid that amount into your mortgage already, because the remainder of your mortgage is worth $100,000, you once again own 0% equity in your home.
But no matter the actual price of your property, once you’ve paid off your mortgage completely, you’ll have 100% equity in your home. (That is, of course, until you take out a loan.)
How Do You Build Home Equity?
Practically, your home equity can increase two ways: as you buy more house and when the market value rises. But there’s more to building home equity than that.
Make a Big Down Payment
The fastest way to build equity is by slapping down a huge chunk of change upfront. This is known as a down payment. The more you pay at closing, the more equity you own immediately.
For instance, if you put down the bare minimum – typically 3-5% of your home’s value – you have a long way to go before you can tap your equity. But if you put 20% down, you can borrow against your equity much sooner.
Keep Up with Your Mortgage Payments
For the first few years of your mortgage, the bulk of your monthly mortgage payment goes toward interest, while a much smaller amount chips way at your principal.
But as you pay down your debt, you’ll build more equity as the interest portion falls and the principal portion rises.
If you keep up with your mortgage payments, you’ll build equity naturally over several decades.
If you want to build equity more quickly, you can make more than your minimum payment each month or opt for biweekly payments. This way, you not only shave a chunk off your loan’s total cost, but you build equity faster, too.
Property Value Appreciation
It’s common to see property values rise, or appreciate, over time. While you probably won’t see the market value leap $100,000 overnight, you might see such appreciation over a decade, depending on your location and any improvements you make.
And if your home appreciates while you’re paying off your mortgage, that translates into instant equity in your favor.
Make Home Improvements
You can also increase the value of your home by making substantial improvements, such as updating the kitchen and bathrooms, building new additions, or investing in a good landscaper.
But bear in mind that some improvements are worth more than others – so if you’re renovating to build equity, it pays to do your research.
How Do You Calculate Home Equity?
Estimating equity is fairly easy – but evaluating it properly can cost a fair sum. To calculate your home equity:
- Determine the balance on your mortgage. Your lender can provide you with this information.
- Estimate the cost of your home or get an appraisal. While an estimate can provide a solid baseline, you’ll probably need to pay for a professional home appraisal to tap your equity.
- Subtract the balance of your loan from the value of your home. For example, if your home is worth $250,000 and you owe $100,000, you would have $150,000 in equity.
How Can You Use Home Equity?
For the average person, their home is their most valuable asset. You can use this asset to obtain funding for various needs by borrowing against your equity or selling your home for a profit.
Get Rid of PMI
Most lenders no longer require a 20% down payment to buy a house. But if you put less than 20% down, you may have to buy PMI, or private mortgage insurance, to offset the risk you’ll default on the loan.
Depending on the value of your home and your premium, you may pay $1,000-$2,000 per year on top of your mortgage.
But once you gain 20% equity in your home, you can cancel your PMI and save a pretty penny.
If you have a conventional loan and keep current on your payments, your insurer will cancel your PMI once you reach 22% or the halfway point of your loan term, whichever comes first.
Make Additional Home Improvements
If you want to make home improvements but don’t have the cash on hand, you can use your house to get a loan.
Depending on the type of loan (such as FHA 203(k) or FHA Title 1 Loans) and value of your improvements, you may be able to write off your interest payments on your taxes!
Mortgages often carry much lower interest rates than other types of loans. If you have a bunch of high-interest debt following you around, you can use a home equity loan, HELOC, or cash-out refinance to cover your debts and save on interest.
Pay Off Student Loans
Tuition nowadays costs an arm and a leg, and for many, taking out student loans (especially high-interest private loans) isn’t ideal. If that sounds like you, you might be relieved to hear you can also tap your home equity to cover your tuition at a low interest rate.
Buy a new house
The more equity you own, the less you’ll pay your lender to buy out your mortgage if you sell. If you own your home outright, you’ll get to take the lion’s share with you (sans selling costs).
But if you don’t, even $50,000 can save you years of stashing away a down payment for a new place.
And the larger your down payment, the more house you can afford – or the less you’ll have to borrow to buy a house of equivalent worth. Hello, smaller mortgage payments!
How Can You Access Your Home Equity?
Once you surpass 20% equity, most mortgage lenders let you tap up to 80% of it with a loan. But exactly how you access your funds is up to you (and your credit score).
Home Equity Loans
A home equity loanlets you borrow against the equity in your home. Because you can take out these loans even if you still have a mortgage, they’re often referred to as second mortgages.
The way these loans work is simple: upon applying and being approved, you’ll receive a lump sum of cash.
Then, you repay your debt in monthly installments at a fixed interest rate for the duration of your term.
Typically, home equity loans are ideal if you need to cover large, immediate expenses. You can also use them to circumvent the exorbitant interest rates on most credit cards.
Home Equity Line of Credit (HELOC)
A home equity line of credit, or HELOC, is a revolving line of credit that works like a credit card backed by the equity in your home.
It, too, qualifies as a second mortgage.
Typically, your lender will set a maximum credit line of up to 80% of your home’s equity. Then, you can pull out and repay funds as needed during the draw period (usually 10 years). Then, during the repayment period (usually 10-20 years), you’ll repay your loan in full.
Like a credit card, you only pay interest on what you owe. But unlike home equity loans, your variable interest rate fluctuates with the market, which makes it difficult to budget payments.
Many people use HELOCs as a backup emergency fund or to cover variable costs, such as ongoing educational or renovation expenses.
>> More: Best HELOC Lenders
A cash-out refinance replaces your current mortgage with a new one worth more than you owe. The excess, or “cash out” of your home, is paid to you as a lump sum loan.
For example, say you owe $100,000 on a $200,000 home. If you were to apply for a cash-out refinance of $150,000, the first $100,000 would pay off your existing mortgage. The remaining $50,000 would go into your pocket.
Typically, a cash-out refinance is a good idea if you want to refinance your home at a lower interest rate and get some cash at the same time. Plus, the money is tax-free! (Though you have to pay it back.)
If you’re over 62 and own your home, you might consider a reverse mortgage, which flips the script on its head and pays you.
Typically, these loans are ideal if you need money in retirement and aren’t worried about leaving an inheritance.
Essentially, a reverse mortgage cashes out the equity in your home in a lump sum, line of credit, or monthly installment payments until your equity is tapped out. You don’t have to repay the loan until you sell your home or move out for more than six months.
Then, when you pass away, the bank can repossess and sell your house. Of if you have heirs, they can restructure the debt into a regular mortgage or sell the house and repay the loan.
Home Equity FAQs
Is equity on a home good?
Yes! The more equity you own, the more of your house you own.
How can you use a home equity loan?
You can use home equity loans and HELOCs for just about anything you want. But some uses (renovations) are more advised than others (vacations).
Do you need an appraisal to get a home equity loan?
Not every lender requires a full appraisal. Some look at county assessments, automated value models, or in-house appraisals to determine your home’s value for loan purposes.
How fast does a home build equity?
The faster you pay off your home, the faster you build equity. Your equity also increases if your home’s value rises.
How much equity can you borrow from your home?
Most lenders let you borrow up to 80% of your home’s equity, though some go up to 90%.
Bottom Line: What is Home Equity?
Home equity provides homeowners with one of the most valuable financial tools they’ll ever access.
Once you’ve built enough equity, you can tap it with a low-interest loan to pay for necessities, upgrades, and other debts.
But you want to be careful biting off more than you can chew, lest you lose your asset in the process.