Home Equity: What It Is and How You Can Use It
Home equity is the part of your home you actually own as determined by market value minus existing liens on the property, including a mortgage or home equity line of credit. Tapping into your home equity to pay off debt or finance home improvements makes sense in some situations.
If you have asked yourself, how does home equity work? Then you have come to the right place.
Home equity is the difference between the value of your home and the current outstanding mortgage debt. Most lenders require you have a down payment of 10% to 20% of the home purchase price. At the time of purchase, that is the value of your home equity.
The amount of your home equity, however, changes over time as you make mortgage payments and the market value of your home increases or decreases. As you build more home equity, you may decide to access it to pay down other types of debt or finance home improvements. However, you need to understand how home equity works to see if this is the right financial move for you.
On this page:
- Why is Building Home Equity Important?
- How to Build Home Equity
- How to Use Home Equity
- How to Get a Home Equity Loan or HELOC
- What is a Reverse Mortgage?
- Can You Lose Home Equity?
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Why is Building Home Equity Important?
It’s important to build equity in your home because it can give you financial flexibility and access to home equity products. Homeowners have the opportunity to access the equity they have built in their home by taking out home equity loans or home equity lines of credit (HELOCs).
Both of these debt products allow homeowners to gain access to their home equity in exchange for cash, which they can use to pay off or consolidate credit card debt, go on vacation, pay college tuition, or renovate their home.
Home equity gives homeowners an additional source of funding and the financial flexibility they need. The amount homeowners can borrow, however, depends on the amount of home equity they currently have. You can learn more about the pros and cons of HELOCs here.
For many Americans, their home is their single largest asset. Building equity in your home is a way to build the value of your assets and increase your net worth. Your home is a unique type of asset because it not only gives you shelter but also creates wealth and financial security.
How to Build Home Equity
Building home equity over time is a simple process. Here’s how to do it:
Buy Your Home
To build home equity, you need to buy your home and quit renting. When you own your home, changes in real estate prices can help your equity increase over time. Under normal market conditions, home values appreciate every year. As the value of your home increases, so does the value of your home equity.
Consider an example in which you owe $200,000 on a home worth $250,000. Imagine that tomorrow, your home increases in value to $260,000. The value of your home equity increased from $50,000 to $60,000.
Any down payment you make when you first purchase your home also gives you equity.
Increase Your Mortgage Payments
Another way to build your home’s equity is by making payments toward your mortgage. Unless you have an interest-only mortgage, every monthly mortgage payment you make gets split between interest and your principal balance. The portion that pays down principal helps you build equity by decreasing your debt.
Unfortunately, at the beginning of your mortgage loan, only a small portion of your payment goes toward principal because most of the money is allocated toward interest. The portion of the payment that pays down principal gets a little bigger each month, though.
You can also make additional payments on your home loan to build equity faster. When you pay more than the monthly minimum, all of the extra money goes to your principal balance.
When you reduce your mortgage balance more quickly by making extra payments, the interest due the following month will be less. As a result, the portion of your next payment that goes to principal will be slightly larger. Every time you pay a little extra on your mortgage, you can increase the rate at which you build equity in your home.
Before you do this, you need to make sure your lender doesn’t impose any prepayment penalties for paying the loan off earlier than planned.
How to Use Home Equity
There are many ways you can tap into your home equity, but two of the most common approaches are a home equity loan or HELOC. Both allow you to borrow against the value of your house in exchange for cash. Here a few key ways you could use the equity you’ve built up.
Home remodels and upgrades can be expensive, especially if you need to make major changes to your house such as removing walls or putting in a new kitchen. Both home equity loans and HELOCs could give you the cash you need to fund a home remodel, but a home equity loan works best when you have a one-off project and need to borrow a set amount of money at once.
Meanwhile, a HELOC makes more sense if you’re doing ongoing renovations and need to borrow funds over time.
>> Read More: Home equity loan or line of credit for home improvements
If you have high-interest credit card debt, debt consolidation could help you significantly reduce your overall interest and simplify payment, especially if you owe money to multiple creditors.
A home equity loan is ideal for debt consolidation because you can borrow a lump sum of money upfront with a predictable payment schedule, so you’ll know exactly when you’ll become debt-free. Home equity loans also generally have fixed interest rates, whereas HELOCs are more likely to have variable interest rates.
Paying for College
Although you can get student loans to pay for higher education, a home equity loan could also be an affordable way to borrow for school, thanks to (usually) lower interest rates. Be aware, however, that a home equity loan doesn’t offer the same borrower protections as federal student loans, such as the ability to defer payments while in school.
In addition, interest on student loans is tax deductible even if you don’t itemize, whereas home equity loan interest is deductible only if you itemize and use the equity to improve or build a home.
Paying for Ongoing Medical Treatments
If you have medical expenses you can’t pay, borrowing against your home equity could be a smart option. A HELOC is often the best source of funds for covering ongoing medical treatments because you can draw from your available credit as you need it versus borrowing a fixed loan amount.
How to Get a Home Equity Loan or HELOC
To get a home equity loan or HELOC, you need enough equity in your home to draw from. Typically, you need to keep your loan-to-value ratio, or the total amount borrowed relative to your home’s value, below 85%. You may need to pay for an appraisal to get a home equity loan or HELOC to show the bank how much your home is worth.
You’ll also need to meet other requirements for a home equity loan or HELOC, such as having a stable income and good credit history.
You can apply with your existing mortgage lender for a home equity loan or HELOC, or you might consider other banks, credit unions, or online lenders that offer those types of products.
What is a Reverse Mortgage?
If you want to tap into your home equity, a reverse mortgage is an alternative to home equity loans or HELOCs. A reverse mortgage is a loan that allows you to tap into your home equity to fund everyday expenses or emergency expenses. Typically, reverse mortgages are available to homeowners over age 62.
The major benefit of a reverse mortgage is it does not require you to make monthly payments. Seniors can stay in their current home, but the borrowed amount eventually has to be paid back if the homeowner passes away or sells the house.
HELOCs or home equity loans can be a better alternative for younger people who don’t qualify for a reverse mortgage, as well as for people who want to work on paying off their borrowed funds immediately rather than having their loan balance continue to grow until the house is sold or the borrower dies.
Can You Lose Home Equity?
With a reverse mortgage, you lose home equity because the amount of your home owned by the lender grows as you receive your borrowed funds. Reverse mortgages aren’t the only way to lose equity in your home, though. Your home equity decreases when the value of your home goes down, which can happen (usually temporarily) throughout homeownership.
At the local level, for example, neighborhoods can fall into disrepair and become less desirable over time. Under these conditions, property values can fall rather than appreciate every year.
At the national level, there are macroeconomic forces that can decrease home values. This is precisely what happened during the 2008 housing crisis. In markets like California and South Florida, homeowners not only saw their home equity decrease but often ended up with a negative amount of equity in their homes, also known as being underwater in your mortgage.
Again, consider the example where you have a $250,000 home and owe $200,000 on the mortgage. If the value of your home fell to $195,000, you would now have negative home equity. Following the housing crisis, many Americans who experienced negative home equity were unable to sell their homes and ended up in foreclosure.
However, having a larger amount of home equity can provide homeowners with some protection against falling home prices.
Building equity in your home helps increase your net worth and gives you a source of funds you can potentially borrow in times of need. It’s important to understand how home equity works and how to tap into it to accomplish both your short- and long-term financial goals. Depending on your situation, a home equity loan or HELOC could be your best bet.