What is home equity and how does it work?

Should you consider getting a home equity loan? Learn more about home equity and how you can use it. Read this article now

What is home equity and how does it work?

There are as many ways to build equity in your home as there are risks. Is a home equity line of credit (HELOC) the right move for you financially? Or are you unable to be disciplined enough to make the proper payments now? Here is everything you need to know about home equity, from how to calculate it and how to boost it.

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What is home equity and how does it work?

Equity in a home is the difference between what your home is currently worth and what you owe on your mortgage. For instance, if you owe $200,000 on your mortgage and your property is worth $250,000, then you have $50,000 of equity in your property.

How home equity increases

Typically, there are two ways that equity in your home increases, which are:

  1. The more money you pay on your mortgage, the more the equity in your home will increase
  2. If the value of your home increases, your equity will also increase.

How home equity decreases

Conversely, the equity in your home can also decrease. For instance, if the value of your property falls faster than the speed you are paying down the principal balance of your mortgage.

How home equity works

If all or some of your property is purchased using a mortgage loan, then your lender will have an interest in your property until the mortgage is repaid. As touched upon, home equity is the portion of your property’s value that you technically own.

This means that the down payment that you have made on your home is the equity that you have acquired initially. Following the initial down payment, your equity keeps growing with every mortgage payment you make, since every payment made reduces the outstanding principal owing.

How to determine equity in your home

If you want to know how much equity you have in your home, you will have to know the value of your property. One way to get an estimate is by looking at what properties like yours, in your area, have recently sold for. For instance, let’s say that number is $200,000. You would then subtract from that the balance of your home loan, which is, for instance, $125,000. That would make your equity $75,000.

Read more: How to calculate your home equity

Home equity formula

In other words, the calculation to determine your equity is as follows:

Home value–loan balance=home equity

Let’s say that after two years of making mortgage payments on time, reducing your loan balance to $100,000, the value of your home then increases to $210,000. The formula becomes this:

$210,000 – $100,000 = $110,000

If in a similar situation the value of your property decreased to $195,000, then the formula is:

$195,000 – $100,000 = $95,000

Can I use home equity to pay off mortgage?

The short answer: Yes. You can use equity to pay off your mortgage. If you have grown enough home equity but still have a mortgage to pay off, you can use a home equity line of credit, or HELOC. Going down this route will not only reduce your monthly payments but also the overall interest you pay on your mortgage.

HELOC: Explained

Like a mortgage, the amount of equity you have in your home secures the home equity line of credit. Where it differs from a mortgage is that a HELOC offers more flexibility, since you can utilize your line of credit to repay what you used, like you do a credit card.

You have the option to use a HELOC to pay off all or portion of your remaining mortgage balance, or for just about any other reason. If approved for a HELOC, you can make mortgage payments before paying your HELOC instead of your mortgage.

Additionally, since HELOC rates are variable, the rate can fluctuate.

HELOC: What you should consider

Repaying your mortgage using a HELOC is like refinancing, except it lets you reduce your interest rate while avoiding the closing costs that come with refinancing.

Before choosing to use a HELOC, there are a few things to consider, both with respect to your current mortgage as well as what your options are with a HELOC and other borrowing options.

First, your mortgage:

  • How much do you owe on your mortgage?
  • What are your monthly mortgage payments?
  • How long will it take to repay your mortgage in full?

Next, let’s take a look at the HELOC considerations:

  • What would your monthly payments be on a HELOC?
  • Does a HELOC provide the option to pay interest-only?
  • How long do you want to make payments on it?
  • How disciplined will you be when it comes to making extra payments on the principal of the HELOC balance?

The final option worthy of consideration is any additional borrowing options. For instance, under a more standard refinance, what would you save in interest?

Is it a good idea to take equity out of your house?

Whether it is a good idea to take equity out of your house or not will depend on various factors, such as how confident you are you will make payments on time. Another consideration is if you are using the loan to make home improvements that will increase the value of the property.

These considerations will change from homeowner to homeowner. If you do fall behind on payments, there are many risks involved. Before opting to take out a home equity loan, here some of the risks, and lender’s terms, that you should consider:

  1. Rising interest rates on some loans
  2. Your home is used as collateral
  3. Equity can fluctuate
  4. Making minimum payments can get you in trouble in the future
  5. Your credit score may fall

Here is a more in-depth look at each of the risks you should consider before taking equity out of your house.

1. Rising interest rates on some loans

Home equity lines of credit (HELOCs) and home equity loans are the two major kinds of loans that use as collateral your home equity. Loan terms depend on each different product and lender, but a HELOC will typically offer adjustable rates, meaning rising interest rates spur higher payments.

In other words, HELOCs are connected to the prime rate, which is at the mercy of rising inflation or interest rates that are increased by federal governments to help mitigate the impact of a turbulent economy. This means that due to unpredictable interest rates, anyone who borrows on a HELOC may wind up paying a lot more money than they initially thought.

2. Your home is used as collateral

If you default on a HELOC, you could potentially lose your house, since it is used as collateral for the loan. This differs from defaulting on a credit card, for example, which simply means your credit is lowered and you will have to pay penalties for any late fees.

Prior to taking out a HELOC or a home equity loan, it is important for you to do thorough research. You will need to ensure that you have a high enough income to make continuous payments and if you can continue to make regular payments if your income is changed in some way. After asking yourself those kinds of questions and doing your research, you may find that a HELOC or home equity loan doesn’t make financial sense for you now.

3. Equity can fluctuate

With the price of houses continuing to increase, it may seem unlikely that your property will suffer a large and damaging loss of value. During the financial housing crisis of 10 years ago, however, that is precisely what occurred. Those plummeting home values had a devastating effect on those homeowners who took out HELOCs or home equity loans. Those homeowners essentially owed more than the home’s value.

4. Making minimum payments can get you in trouble

Interest-only payments are required for most HELOCs during the first 10 years. You are allowed to access the credit of the loan during that draw period. You will not make any progress in paying off the principal of the loan, however, if you only make those minimum payments.

When that draw period ends, you enter a period of repayment where you must pay both on the principal and on the interest and are no longer able to draw from the line of credit. By making minimum payments on the large amount of money borrowed during the draw period, you will likely have an unwelcome surprise after that period ends—that’s when the principal balance will be added to your bill.

5. Your credit score may fall

Your credit score may also be impacted if you open a home equity loan, since that score comprises of multiple factors. One such factor is how much of your available credit you are using. If you add a significant home equity loan to your credit report, your credit score could be damaged.

Conversely, your credit score may actually be improved if you take out a home equity loan and regularly make monthly repayments.

How can I build up equity in my home?

The good news is that you can build up equity in your home in numerous ways. Here are some of those ways:

  1. Large down payment
  2. Pay off your mortgage
  3. Pay more than the minimum
  4. Live in the home for at least five years
  5. Add curb appeal

Here is a more in-depth breakdown of how to build up equity in your home.

1: Large down payment

Making a big down payment is perhaps the quickest possible way to build up your home’s equity. As mentioned, you will have more equity in your home instantly the larger down payment you make.

If you purchase your property for $200,000 and you make a $10,000 down payment, you will owe $190,000 on your mortgage and have $10,000 in equity. By making a $20,000 down payment, you will owe $180,000 and have $20,000 in equity—twice as much right off the bat.

By understanding how much financial sense it makes for you to make a large down payment, you will understand better how to build equity in your home. It would also help you to get pre-approved for a mortgage prior to making any offer on a property, simply so that you know how much of your savings you will have to use toward the down payment.

2: Pay off your mortgage

Mortgage payments go toward paying off the principal balance of your home loan, with the remainder typically paying off things like property taxes, interest, and homeowners’ insurance. At the beginning of your mortgage payments, a lesser amount goes toward repaying the principal balance and a larger amount will pay off your interest.

On the plus side, however, more money will go toward paying off your principal balance, the longer you have a mortgage—which means the more equity you will build.

This is common, but, once again, it is important to do your research, since some loans operate differently. For instance, if you take out a non-amortizing mortgage such as an interest-only loan, you will not be building equity because you will not be paying your principal balance.

In fact, in these scenarios, your money will only go to paying your property taxes, interest, and/or insurance. In other words, to pay off your principal balance, you will be forced to pay a lump sum.

3: Pay more than the minimum

Paying more than you have to every month is a good way to build home equity. This could mean something as simple as making an extra payment every year or even paying an extra $100 per month.

4: Live in the home for at least five years

This will help you to build equity if the value of your property rises. By living in your house longer, you will increase the likelihood that the value of the home will increase. Staying in your house for five years or more could give you a boost in equity if the value of the property spikes.

5: Add curb appeal     

What is a good way to add curb appeal? Renovation. By adding an extra bedroom, updating your kitchen, or renovating the master bedroom, you can add value to your home—and equity. You will especially add curb appeal if you landscape your front yard.

Have experience with home equity? Let us know in the comment section below.