You've probably heard that one of the benefits of owning a home is that you can build equity in it and that you can tap that equity to pay for a major kitchen remodel, eliminate your high-interest credit card debt or even help cover your children's college tuition.
But what exactly is equity, and how can you use it? Here's a quick guide to the basics of how home equity works and why it's so valuable.
What Is Equity?
Equity is the difference between what you owe on your mortgage and what your home is currently worth. If you owe $150,000 on your mortgage loan and your home is worth $200,000, you have $50,000 of equity in your home.
Your equity can increase in two ways. As you pay down your mortgage, the amount of equity in your home will rise. Your equity will also increase if the value of your home jumps.
Your equity can fall too if your home’s value drops at a rate faster than the speed at which you are paying down your mortgage’s principal balance.
How Equity Works
Here’s an example of how equity can change over time. Say you buy a house for $200,000. You might come up with a down payment of 10% of your home’s purchase price, $20,000. Your lender will then provide you with a mortgage loan of $180,000.
If your home is worth that $200,000 sales price, you now have $20,000 of equity, or $200,000 minus $180,000.
Jump ahead 2 years. You’ve been making your mortgage payments on time, and you might now owe $170,000 on your mortgage. Maybe your home’s value has jumped too during this time to $210,000. You now have $40,000 in equity, or $210,000 minus $170,000.
Your home’s value could work against you, too. Say you’ve paid down your mortgage loan to that same $170,000, but your home’s value has actually dipped to $195,000. Now you have $25,000 in equity, or $195,000 minus $170,000.
To determine your equity at any one time, you’ll need to know the value of your home. Only a real estate appraiser can give an official valuation of what your home is worth in today’s market. You can, though, estimate your home’s value by looking at comparable home sales in your area or by checking with online real estate sales that provide their own home value estimates. Just remember that these estimates aren’t always accurate and exist just to give you a rough idea of your home’s current worth.
How To Build Equity
Fortunately, there are a number of ways to build equity in your home.
Make A Big Down Payment
The fastest way to build equity is to come up with a large down payment. The bigger your down payment, the more equity you’ll immediately have in your home. Say you buy your home for $180,000. If you put down $5,000, you’ll owe $175,000 on your mortgage. That leaves you with $5,000 in equity. If you put down $20,000, you’ll owe $160,000 on a home worth $180,000. That’s a far more impressive $20,000 in equity.
Focus On Paying Off Your Mortgage
A portion of each mortgage payment you make will go toward paying down the principal balance of your home loan. The rest will usually go toward paying interest, property taxes and homeowners insurance. When you first start making your mortgage payments, a smaller amount will go toward reducing your principal balance and more of your dollars will go toward paying down your interest. The good news, though, is that the longer you have your mortgage, the more money will go toward reducing your principal balance and building your equity.
Be aware, though, that some loans don’t operate this way. If you take out an interest-only or other non-amortizing mortgage, you won’t reduce your principal balance or build equity. Instead, your payments will only go toward paying your interest, property taxes and insurance. Eventually, you’ll need to pay a lump sum to pay off your principal balance.
Pay More Than The Minimum
If you want to build equity more quickly, you can always pay more than your required payment each month. Even paying an extra $100 a month can help you chip away at your principal balance at a faster rate. You might also choose to make an extra payment each year, another way to decrease your loan’s principal balance and build equity faster.
Stay In Your Home 5 Years Or More
You’ll build equity if your home increases in value. Of course, no home is guaranteed to see its value jump, but you will increase your odds if you stay in your residence for a greater number of years. Plan on staying in your home for 5 years or more if you want to see its value jump enough to give you an equity boost.
Renovate And Add Curb Appeal
You can help boost your home’s value by adding an extra bedroom, renovating that old kitchen or adding a master bathroom. Investing in landscaping and giving your home curb appeal can help too.
How To Use Your Equity
Equity is an important financial tool and one of the greatest financial benefits of owning a home. You can tap into this equity when you sell your current home and move up to a larger, more expensive one. You can also use that equity to pay for major home improvements or to help consolidate other debts. You can even use it to help plan for your retirement.
Not all homeowners have equity in their homes. Fortunately, though, most do. And some owners are equity-rich. This means they have at least 50% equity in their homes. ATTOM Data Solutions, a property data provider based in Irvine, California, reports that more than 14 million homes in the United States were equity-rich as of the end of the first quarter of this year. That’s more than 25% of all the homes in the country.
Using Equity To Help Buy A New Home
Maybe you've lived in your home for 7, 8 or 9 years. Maybe your family continues to grow. Or maybe your job is taking you to a new city. Whatever the reason, you're ready to sell your home and find a new place to live.
Equity can be your friend as you make this move.
Maybe the home you are selling is worth $220,000, and maybe you've built $70,000 worth of equity in it. If you sell your home for what it's worth, you'll leave the closing table with a profit. You probably won't get the entire $70,000 in equity you've built. You'll need to pay for such fees as your real estate agent's commission and some mortgage closing costs. But you will end up with a solid profit that you can then use for a large down payment on your next home.
With this big down payment, you can get into a larger, more expensive home because your mortgage will be lower. And with a smaller mortgage, your monthly mortgage payment will be lower too. If your down payment is big enough, your monthly mortgage payment might be smaller than it was with the residence you sold, even if that home was smaller and less expensive.
Borrowing Against Equity
There are three main ways you can borrow against your home’s equity: a home equity loan, a home equity line of credit or a cash-out refinance. Using equity is a smart way to borrow money because home equity money comes with lower interest rates. If you instead turned to personal loans or credit cards, the interest you'd pay on the money you borrowed would be far higher.
There is a potential danger to home equity lending, though. If you fail to make your payments on time, your lender could take your home through the foreclosure process. That can't happen when you take out a personal loan or when you charge purchases with your credit cards.
Home Equity Loans
A home equity loan works like a second mortgage. Say you have $50,000 in equity. You might qualify for a home equity loan of $40,000. Once the loan closes, your lender will provide you this $40,000 in a single payment. You can then use this money however you want. You pay this loan back in monthly installments, with interest, just as you pay back your primary mortgage loan.
Home Equity Line Of Credit
Better known as a HELOC, a home equity line of credit is more like a credit card, only the credit limit is tied to the equity in your home. If you have $40,000 of equity, you might qualify for a HELOC with a maximum spending limit of $30,000. This means you can borrow up to $30,000, but no more. As with a credit card, you only pay back what you borrow. So if you only borrow $20,000 on a kitchen renovation, that's all you have to pay back, not the full $30,000.
In a cash-out refinance, you refinance for more than what you owe on your mortgage. You again receive this extra money in cash that you can use however you want. Say you owe $180,000 on your mortgage. You can refinance for $220,000 and then take the extra $40,000 in cash. You will repay the $220,000 total in monthly payments, with interest. How much extra you can include in your cash-out refinance depends on the equity in your home.
Before deciding on any of these home equity choices, be sure to speak with a mortgage professional who can help you understand the pros and cons of each.
Using Equity For Your Retirement
If you're 62 or older and considering retirement, you might explore a reverse mortgage. With a reverse mortgage, you'll stop making your monthly mortgage payments and will instead receive money based on the equity in your home.1
How much you can borrow depends on your age and how much equity you have in your home as well as current interest rates. Maybe you have $200,000 of equity in your home. You might then be able to qualify for a reverse mortgage of $130,000. You can elect to receive this money in one lump sum, regular monthly payments or a line of credit. Any combination of the three payment schemes is also possible.
You don't pay back your loan unless you sell your home, move out for more than 6 months out of the year or pass away. You would then use the profits from your home sale to pay back the loan. If you pass away, your heirs have options. They can choose to sell the home (keeping any profits after the loan is paid off), refinance into a regular forward mortgage or walk away and let the lender sell the home. A reverse mortgage is a nonrecourse loan, meaning your heirs won’t be forced to pay back anything more than what they can get from the sale of the home.
1Homeowner is still responsible for taxes, insurance and property maintenance.