What Is Home Equity and How Does It Work?
What is equity?
You’ll often hear the term equity when it comes to homeownership, but you may not even know what that means even if you already own a home. The amount of money you receive when you sell your house, minus any debt associated with it, is equity. When looking at it from an investment point of view, the owner of the asset (probably you in this case) is referred to as a stakeholder. There are two types of equity: book value and market value. Equity calculations occur most often in businesses and homes.
Calculating the difference between an asset and its liabilities determines the equity’s book value. An equity’s market value is based on the valuation of investors, or its current share price if you’re calculating the market value for a business. For a home, fair market value is typically what people in the consumer marketplace are willing to pay for your house.
Understanding home equity
Say you want to determine how much equity you have in your own home. You can take its current value and subtract the amount you still owe. For example, if your home’s value is currently $130,000 and you still owe $80,000, you have $50,000 of equity. Two factors affect your home’s equity:
- If appreciation occurs due to home/property improvements or inflation
- Paying down the principal that you owe on your original mortgage
When you make a down payment during your initial purchase, that helps bring down the amount you owe on the mortgage. Down payments are both a portion of the home’s total selling price, as well as your initial equity stake. Many mortgages, like a VA loan or USDA-backed loan, don’t require a down payment, however, it’s common for homeowners to put down between 3-5%.
The loan interest you have on your mortgage affects how quickly you can build equity. Your loan interest is a percentage of your total balance, which most pay monthly until the end of the mortgage term. Loan collateral is when you take out a loan and, in the case of real estate, the home becomes collateral. This reduces a lender’s risk; if the loan goes into default they can sell the collateral to recoup costs.
The term lien means you have a legal right or claim against a property. The first time a home lien happens is when you obtain the original mortgage. In that scenario, the lien is helpful because the home becomes loan collateral and you can build equity. Keeping up with your mortgage payments helps ensure any other lien doesn’t attach to the loan. So make sure you’re paying it on time to keep any liens away.
What happens to my equity if my home increases in value?
Let’s take the earlier example of your home being currently worth $130,000. You owe $80,000, so there is $50,000 in equity. Now, assume that the initial cost of your home was $100,000, and you made a 10% down payment at purchase. That percentage is also known as your equity stake. If you don’t incur any additional debt on your home, its equity will continue increasing as you make payments and its value increases.
$100,000 – 10% ($10,000) = $90,000 (original amount of the loan before making payments)
- Original loan: $90,000
- Payments to date: $10,000 ($90,000 – $10,000 = $80,000 owed)
- Value of home: $130,000
- Equity: $50,000 ($130,000 – $80,000 = $50,000 equity)
Tips on how to build home equity
There are lots of ways to build equity, including one that requires no work at all. When your property value increases due to rising prices in the housing market, you’re building home equity. Here are some additional ways you can build home equity:
- Lowering your mortgage balance: The more you pay against your mortgage’s principal, the more equity you’ll have. Just make sure there are no pre-payment penalties.
- Making larger mortgage payments: Each time you pay extra on your mortgage and apply that difference to the loan’s principal, you’re building equity.
- Change the payment schedule: By making 26 half-payments instead of 12 full payments, you reduce the term of your loan, saving on interest and building equity faster.
- Refinance the terms: If you opt to refinance your loan to a shorter-term 15-year loan, you’ll have higher payments but you will build equity faster than with a traditional 30-year loan.
- Make improvements: Some home improvements increase the property’s worth and thereby your equity. But only certain types of improvements will pay off, so research for your area accordingly. And don’t forget curb appeal.
- Keep it maintained: Keeping up with regular repairs and maintenance can increase your home’s worth when it comes time to sell, which results in higher equity.
Home equity loans
One of the most beneficial aspects of a mortgage is the ability to borrow against your equity. You can do that with a lump-sum loan or home equity line of credit.
How does a home equity loan work?
There are two types of home equity loans: lump-sum loans and the home equity line of credit.
- Lump-sum home equity loan: A lump-sum home equity loan means lenders are allowing you to borrow a lump-sum of money against your existing equity. Because they fund in a lump sum, they’re similar to a personal loan.
- Home equity line of credit (HELOC): A HELOC is a loan where the lender qualifies you for a revolving line of credit against a percentage of your home equity. This loan works similarly to a credit card whereby you carry the balance from month-to-month for the amount you’re allowed to borrow against your home’s equity.
Qualifying for a home equity loan
Qualifying for a lump-sum home equity loan means the lender looks at your credit history, income, the home’s current value and your debt-to-income ratio. When you’re trying to qualify for a HELOC, you must have at least 15-20% of your home’s value in equity. That determination occurs following an appraisal. You must also have a debt-to-income ratio that does not exceed roughly 40% (or a bit higher) and a credit score above 620.
Pros and cons of home equity loans
- Easy qualification: If a lender knows they can use your home as collateral they are more likely to qualify you for and approve your application.
- Lower interest rates: Even if the home equity loan is challenging to get, you may find it has lower interest rates.
- Risk: If you cannot make your loan payments, you risk the home going into foreclosure.
- Limitations: If you want to sell your home, you must pay off your home equity debt first.
Frequently Asked Questions
What is equity and how do I find out my home equity? Equity is the amount of money an asset owner receives when they sell their house, minus any debt associated with it. To find your home equity, your first step is getting an appraisal. Then, take the value of the appraisal and subtract it from the amount you still owe on your mortgage.
Is it a good idea to take equity out of your house? If you need to make home improvements, cover costs for college, consolidate debt, obtain emergency expenses or secure long-term investments, then you may want to apply for a home equity loan (assuming, of course, you can afford the increased mortgage payment).
What credit score do you need to get a home equity loan? You have a better chance of qualifying if your credit score is 700 or above.
Which is better to get—a home equity loan or personal loan? If you need a substantial amount of funds, it’s more challenging to get a personal loan. A home equity loan allows you to repay over a longer-term as well.
Are there closing costs on a home equity loan? Though rates differ from lender to lender, expect to pay between 2-5% of the loan in closing costs. However, it isn’t uncommon for lenders to waive these fees.
Jenn Greenleaf is a professional writer from Maine who also works part-time as a bookkeeper for her husband’s residential construction business. She specializes in writing about HVAC, commercial construction, and other home-related topics.