Home equity is the value of your home after deducting the balance of any loans where your home acts as collateral, such as mortgages and home equity loans. For example, if your home’s value is $300,000, and your mortgage is $270,000, your home equity is $30,000 (10%).
Your home equity will generally increase over time as you pay your mortgage or improve your home. Plus, the market value of real estate often appreciates (goes up). When this happens—so long as you haven’t increased the debt on your home—your home equity also increases.
One option for your home equity is to leave it alone and focus on paying off your debt. You can also use your home equity for projects such as renovating or improving your home, refinancing higher-rate debt, or paying for college. Before you decide how to use your home equity, it’s crucial to understand how it works to see whether it’s the right financial move.
In this guide:
- How does home equity work?
- Why is building home equity important?
- How to build home equity
- How to use home equity
- Which financial products use your home equity?
- How to get a home equity loan or HELOC
- Can you lose home equity?
- What do homeowners most often use their home equity for?
How does home equity work?
At the most basic level, home equity is the value of your home minus the balance of any outstanding loans against your home, such as a mortgage or home equity loan. The most accurate way to estimate the value of your home is to get an appraisal from a licensed appraiser.
If you don’t have a current appraisal, you can estimate your home’s value in one of three ways:
- Get a broker price opinion from a local real estate expert.
- Use an online real estate value estimator.
- Contact the tax assessor for your municipality to find out your property’s tax-assessed value.
After you’ve identified your home’s appraised value (or you’ve gotten another less accurate value estimate), you’ll need to determine the balance on your mortgage and any other debt you have on your home.
With this information on hand, you can calculate your home equity as follows:
- Home equity ($) = Estimated home value minus Home loan balances
- Home equity (%) = Home equity ($) divided by Estimated home value
The following examples show estimated home equity under three scenarios:
|Scenario 1||Scenario 2||Scenario 3|
|Estimated home value||$350,000||$350,000||$350,000|
|Home loan balances||$315,000||$280,000||$367,500|
|Home equity amount ($)||$35,000||$70,000||($17,500)|
|Home equity percent (%)||10%||20%||(5%)|
Note: Home equity isn’t always positive. As we’ve shown in scenario three, it’s possible to have negative equity in your home. Negative equity happens when you owe more than your home is worth. This can occur if property values decline and you have a high home loan balance.
For this reason, the more equity you build up in your home, the less likely you’ll find yourself in a situation where the value of your home is less than the debt you owe on it.
>> Read more: How to calculate home equity
Why is building home equity important?
Building home equity gives you the flexibility to use it for many purposes. Below are several examples of why building home equity is advantageous:
- You can build long-term wealth. For many Americans, their home is their single largest asset. Building equity in your home is a way to increase your net worth. Your home is a unique asset because it provides shelter while creating wealth and financial security.
- Your financial flexibility increases as you reduce your debt. One way to increase your home equity is to reduce the debt you owe on your home. As you pay off your home loans, you can use the money you would have spent on loan payments as you wish (e.g., start your dream business or retire).
- You can borrow your equity using a loan. Homeowners can access the equity they’ve built in their homes by taking out home equity loans or home equity lines of credit (HELOCs). The funds can consolidate higher-rate debt, fund renovations, pay college tuition, and more.
- You can sell your home for more than you owe. If you have equity in your home and want or need to sell your home, you have the flexibility to do so and use the funds as you want—to buy another home or pocket the cash, for instance. You may be unable to do this if you haven’t built up equity.
Building home equity allows homeowners to increase their net worth, benefit from increased financial flexibility, sell their home, or even use their home’s equity as an additional funding source.
Keep in mind if you want to use the equity in your home as a funding source, the amount you can borrow depends on how much equity you have in your home. You can find out more about the pros and cons of HELOCs here.
How to build home equity
Building home equity over time is simple. Here’s how to do it.
Buy your home
To build home equity, you must 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 your home equity.
Let’s say you buy a home for $250,000, and its value appreciates by 3.5% per year, on average. As shown below, at the end of 10 years, you would have built $90,724 in equity just from the value appreciation.
If the average annual increase were 2%, you would still have $48,773 equity in your home.
Besides benefiting from potential value appreciation, any down payment you make when purchasing your home gives you equity. Plus, you can build “sweat equity” in your home by making improvements using your labor instead of paying a contractor (if you have the skills to do so).
Make 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 goes to the principal builds equity by decreasing your debt.
Let’s say you buy a home for $250,000 with a 30-year term, a fixed rate of 7%, a 10% down payment, and a loan amount of $225,000. The following table shows how the equity in your home would build every five years just by making on-time mortgage payments.
|Beginning of period mortgage balance||End of period mortgage balance||Cumulative home equity from principal payments|
|Years 1 to 5||$225,000.00||$211,796.08||$13,203.92|
|Years 6 to 10||$211,796.08||$193,077.86||$31,922.14|
|Years 11 to 15||$193,077.86||$166,542.45||$58,457.55|
|Years 16 to 20||$166,542.45||$128,925.18||$96,074.82|
|Years 21 to 25||$128,925.18||$75,597.98||$149,402.02|
|Years 26 to 30||$75,597.98||$0.00||$225,000.00|
As you can see above, by the time you’ve reached the end of year 15, you will have built $58,457.55 in additional cumulative home equity just by paying your mortgage. This doesn’t include other equity you’ve built from your down payment, value appreciation, or sweat equity.
Paying off your mortgage faster by making extra payments or choosing a shorter term can also help you create equity faster. Based on our previous example, if you chose a 15-year term instead of a 30-year one, you’d pay off your entire loan in 15 years, summarized below.
|Beginning of period mortgage balance||End of period mortgage balance||Cumulative home equity from principal payments|
|Years 1 to 5||$225,000.00||$174,178.80||$50,821.20|
|Years 6 to 10||$174,178.80||$102,133.39||$122,866.61|
|Years 11 to 15||$102,133.39||$0.00||$225,000.00|
As shown above, you would have already built $50,821.20 in equity at the end of five years just by making payments. Even with a 30-year mortgage, you can achieve something similar by doubling your payments (you’ll likely pay off your loan even faster).
However, before you make extra mortgage payments, ensure your lender doesn’t impose prepayment penalties for paying off the principal earlier than planned.
How to use home equity
Two of the most common ways to tap into your equity are a home equity loan and a HELOC. Both allow you to borrow against the value of your house in exchange for cash. You can use the equity you’ve built up for almost any purpose. We’ve listed the most common ways below.
Home remodels and upgrades can be expensive, especially if you need to make significant changes to your house, such as removing walls or installing a new kitchen. You can borrow some of your home equity to get the cash you need to fund an extensive home remodel or even to take care of one-off projects.
Ways you could use your home equity to improve features of your home include:
- Adding a new home office
- Installing a pool
- Repairing your roof
- Upgrading your appliances
- Refreshing your landscaping
- Making energy efficiency improvements
- Building a guest house
Note: These are not all capital improvements that would increase the home’s value or qualify for an interest deduction according to IRS guidelines.
If you have high-interest credit card debt, debt consolidation can reduce your overall interest and simplify the payment process, especially if you owe money to multiple creditors.
As we noted, by using your home equity to consolidate your debt, you’ll pay a lower interest rate than with unsecured loans. When you use your home equity to get a loan, the lender has rights to your home if you don’t pay as agreed. The lender’s risk is less, resulting in a lower rate.
While you may benefit from a lower rate by using your equity to consolidate debt, remember that you’re risking your home. If you don’t repay the equity you borrowed as you agreed, your lender could foreclose on your home to get paid. So, keep this in mind before you proceed.
Also, when deciding if you should use your home equity to consolidate debt, consider how long you need to repay the debt. Even though the rate is lower on a loan secured by your home, you may pay more interest over time if you have a longer repayment term (e.g., 15 years versus three years).
Pay 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.
>>Read more: HELOC to pay off student loans
Pay for ongoing medical treatments
If you have medical expenses you can’t pay, borrowing against your home equity could be a wise option. You could use your home equity to pay one large medical bill or cover ongoing treatment costs.
Not only will you likely receive a lower interest rate by using your home equity than you will with other options (e.g., a credit card), but you might be able to borrow more money. Even so, make sure you can repay the amount and choose the shortest possible repayment term.
Every time you take out some of your home’s equity as a loan, you’re placing additional risk on one of your most valuable assets (your home) since you’re offering your home as collateral to your lender. If you don’t pay as agreed, your lender can pursue foreclosure as a remedy.
Plus, repay the equity you borrow from your home as quickly as possible. This is because the longer you repay the debt, the more interest you’ll pay.
Which financial products use your home equity?
There are many financial products you can access to use your home equity. Several of the most common examples include a home equity loan, home equity line of credit (HELOC), cash-out refinance, and a reverse mortgage.
Home equity loan
A home equity loan allows you to borrow some of the equity you’ve built in your home in one lump sum. It’s good if you have a sizeable one-time need. For example, it can be an excellent way to fund a large home improvement project (e.g., building an addition) or consolidate debt.
You’ll often repay a home equity loan similar to a mortgage in equal installments over 10 to 30 years with a fixed interest rate for the duration of the loan’s term. Since this is a second home loan behind your mortgage, you’ll need to make two monthly payments on your home.
The amount you can borrow will depend on how much equity you have in your home. You may need to keep 10% to 15% equity in your home. As such, you must ensure you have enough equity before considering this option.
Home equity line of credit
A home equity line of credit (HELOC) is similar to a credit card in that you can use and repay as many times as you want. For this reason, a HELOC is best used to pay for costs you think you can quickly repay.
HELOCs often come with two borrowing periods – an initial period with a variable rate where you can use the line of credit and pay back the funds as much as you want (often up to 10 years) and a second repayment period where you need to repay the balance on your HELOC via fixed monthly payments.
Remember that you’ll only be required to make interest-only payments during the HELOC’s initial period. If you don’t pay back the principal quickly, you could incur significant interest costs. So only use the HELOC if you have a plan to repay the funds.
A cash-out refinance is the same as a traditional mortgage refinance, except the purpose of the refinance is to allow you to take some of your equity out of your home in cash. It’s best for sizeable one-time funding needs, as you’ll get the money you take out of your home in one lump sum.
If you don’t want to hassle with making two monthly payments, a cash-out refinance can be an excellent alternative to a home equity loan. This is because you’ll refinance your existing mortgage into a new mortgage via the cash-out refinance.
Similar to a home equity loan, you can use a cash-out refinance for things like funding home improvements, consolidating debt, or covering almost any other significant one-time funding need.
A reverse mortgage is a loan people at least 62 can use to access their home equity. This differs from the other options because your lender will generally cash out your equity incrementally via monthly payments. So, it’s a way to use your equity to create an income stream to fund your retirement.
Even after all the equity in your home is paid out, you can keep living in your home. You won’t need to make any payments on the amount you received from the reverse mortgage. When you pass away, the lender gets the rights to your home.
How to get a home equity loan or HELOC
The steps you should take to get a home equity loan or HELOC include:
- Consider if you have enough home equity. To get a home equity loan or HELOC, you must have enough available home equity. Expect to need to keep your loan-to-value ratio, or the total amount borrowed relative to your home’s value, below 85%.
- Evaluate if you will likely meet the lender’s creditworthiness standards. Besides sufficient equity, you’ll need to meet other requirements for a home equity loan or HELOC, such as a stable income and solid credit history.
- Apply for financing. You can apply with your mortgage lender for a home equity loan or HELOC, or you might consider other banks, credit unions, or online lenders offering those products.
- Get an appraisal on your home. Once you’ve applied and are preapproved for the loan, your lender will order an appraisal to verify how much your home is worth. You may be required to pay for the appraisal, or the lender might cover these costs.
- Sign the loan documents and receive funding. Assuming the appraisal shows you have enough equity in your home and you’ve met all the other lender’s qualifications, you’ll sign the loan documents and get funded.
Before you start the process of getting a home equity loan or HELOC, you can use our home equity loan calculator to determine how much you could borrow.
Can you lose home equity?
You can lose home equity in several ways. For instance, you might lose equity if your home or neighborhood falls into disrepair or becomes less desirable. You can also lose equity if macroeconomic conditions cause home values to decline. Plus, you can lose equity with a reverse mortgage.
With a reverse mortgage, you lose home equity because the percentage 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 any time the value of your home goes down.
Local homes and neighborhoods can fall into disrepair and become less desirable over time. Under these conditions, property values can decrease rather than increase. Plus, macroeconomic forces at the national level can reduce home values, such as during the 2008 housing crisis.
In markets including California and South Florida, homeowners saw their home equity decrease and often ended up with negative home equity. A more significant amount of home equity can protect homeowners against falling home prices and help them preserve some equity.
>>Read more: How to sell equity in your home
What do homeowners most often use their home equity for?
Common ways homeowners use their home equity include:
- Pay for home improvements or repairs
- Fund educational costs for themselves or their children
- Cover significant one-time expenses (vacations, weddings, or medical bills)
- Start a new business venture
- Consolidate higher-interest-rate debt, like credit cards
- Convert their equity into a regular income stream (e.g., via a reverse mortgage)
- Give funds to an adult child for a down payment on a home
How long does it take to build home equity?
The time it takes to build home equity depends on factors such as the size of your down payment, the level of market appreciation, the home improvements you make, and the term of your mortgage. The shorter the term, the faster you’ll build equity (e.g., 100% equity in 15 years with a 15-year mortgage).
How much of your home equity can you borrow?
The amount of home equity you can borrow varies by lender, but many lenders want you to keep at least 15% equity in your home. Other lenders may allow you to keep as little as 5% equity in your home. The better your credit, the more home equity your lender may let you borrow.