The value of a homeowner's interest in a home is referred to as home equity. It can rise over time as the property's value rises or as you pay down the mortgage loan balance.
Home Equity Definition and Example
The current value of your home is the starting point for home equity. Subtract the amounts owed on any mortgages or other liens on the property. Could purchase these liens loans used to purchase the home or took out second mortgages later. The distinction is your home equity. Assume your house is worth 300,000 dollars. If you still owe $200,000 on your mortgage, your home equity is $100,000. Unless you have a shared equity mortgage, which is uncommon, your lender does not own any part of the property. The house is yours, but it is being used as collateral for your loan. Your lender protects its interest by obtaining a lien on it.How Does Home Equity Work?
Assume you want to buy a house for $200,000. Your home equity interest is 20% of the purchase price: The house is worth $200,000, and you put down $40,000, or 20% of the purchase price. You only "own" $40,000 of it despite being the owner. You put down 20% and get a mortgage loan to cover the remaining $160,000 balance. Assume that the housing market improves and your home's value doubles. If the house is now worth $400,000 and you owe only $160,000, you have a 60% equity stake. Your loan balance would remain the same, but because the home's value has increased, your home equity would also increase.Tip:
Divide the loan balance by the market value, then subtract the result from 1 and convert the decimal to a percentage to calculate your equity stake. The equation would be as follows: 160,000 ÷ 400,000 = 0.4 1 - 0.4 = 0.6 60 percent = 0.6How Do You Increase Your Home Equity?
You can take a few steps to increase your home's equity as a homeowner. Repay the loan (s) Most mortgages are standard amortized loans with equal monthly payments covering both interest and principal. As you pay down your loan balances, your equity grows. The amount paid toward principal repayment grows over time, allowing you to build equity faster each year. To determine your payoff date, use our loan amortization calculator. If you had an interest-only loan or another non-amortizing loan, you wouldn't be able to build equity in the same way. In that case, you may need to make additional payments to reduce your debt and increase your equity. The equity rises when the value of your home does. You can actively work to increase the value of your home through home improvement projects. When the real estate market is healthy and growing, house prices rise, and you build equity without doing anything.Payments in Advance
One popular method for accumulating home equity faster is the concept of "accelerated mortgage payments." Most homeowners make monthly mortgage payments, for 12 payments per year. If you split your monthly payment into two equal amounts and send your payment every two weeks, you'll make 26 payments per year: 26 is the product of 365 days per year divided by 14 days. This pattern corresponds to making 13 monthly payments. Using this method will save you a significant amount of interest over the life of the loan. It will allow you to pay off your mortgage faster and accumulate equity sooner. If you have a $100,000, 30-year conventional mortgage at 5% interest, making monthly payments would result in $93,256 in interest over 30 years. If you made half of your monthly payment every two weeks instead, it would reduce your interest payments to $75,489 and pay off the loan in 25 years. You would save approximately $17,767 in interest and own your home free and clear five years sooner.Important:
Before you decide to go that route, check with your lender to make sure there are no restrictions on making biweekly payments.How to Make Use of Home Equity
Because equity is an asset, it accounts for a portion of your total net worth. If necessary, you can take partial or lump-sum withdrawals from your equity or save it and pass all of the wealth on to your heirs. If you decide to use some of your home equity, there are a few options for putting your asset to work.Sell Your Residence
If and when you decide to sell your home, you can take your equity with you. If you still owe on any mortgages, you won't be able to use all of the money from your buyer, but you will be able to use your equity to buy a new home or supplement your savings.Borrowing Against Equity
With a home equity loan, also known as a "second mortgage," you can get cash and use it to fund almost anything. This allows you to live there still while also accessing your home equity. However, your goal as a homeowner should be to build equity, so rather than spending it, that borrowed money toward long-term investment in your future. This allows you to live there still while also accessing your home equity. Paying current expenses with a home equity loan is risky because you may lose your home if you fall behind on payments and cannot catch up.Save for Retirement
A reverse mortgage allows you to spend down your equity in your golden years. These loans provide retirement income. You are not required to make monthly payments. When you leave the house, you repay the loan. These loans are difficult to understand. They may cause issues for homeowners and heirs. The requirements for a reverse mortgage can be complicated. First, you must be at least 62 years old and live in the home as your primary residence.Home Equity Loan Varieties
Home equity loans are appealing because they give you access to a large sum of money at relatively low-interest rates. They are also relatively simple to qualify for because the loans are secured by real estate. Examine how these loans work carefully so that you fully understand the potential benefits and risks before borrowing money against the equity in your home.Loan in One Payment
You can get the money all at once and repay it in monthly installments. The timeline could be as short as five years or as long as fifteen years or more. Although you will be charged interest on the entire amount, these loans may be a good option if you need a large, one-time cash outlay. You may wish to consolidate higher-interest debts, such as credit cards or go on a vacation. With this type of loan, your interest rate is often fixed, so there will be no surprise increases later, but you will most likely have to pay closing costs and fees to obtain the loan.Home equity lines of credit (HELOCs) offer versatility.
A HELOC allows you to withdraw funds as needed. You only pay interest on what you borrow. As with a credit card, you can withdraw as much money as you need during the "draw period" as long as your line of credit is open.Note:
HELOCs are frequently used for expenses spread over several years, such as minor home renovations, college tuition payments, and assisting family members who are struggling. You must make small payments on your debt during the draw period, which typically lasts 10 or 12 years. You then enter a repayment period in which you repay the entire debt. A giant balloon payment at the end of the repayment period is possible. HELOCs frequently have variable interest rates, which means you could end up paying much more than you planned for over the life of the loan.Tip:
Your interest may be tax-deductible depending on how you use the loan proceeds.The Dangers of Borrowing Against Home Equity
One disadvantage of using home equity is that your home serves as collateral for the loan. If you cannot repay the loan for any reason, your lender may foreclose on your home and sell it to repay your debt. Because it would sell the house quickly, it would likely not command the highest or best price. You and your family will have to find new housing, which will add to your financial woes. It's a good idea not to spend your windfall on designer clothes, big-screen TVs, luxury cars, or anything else that doesn't add value to your home. One safer option is to save money for those treats or spread the cost using a credit card with a 0% intro APR offer.How to Get Approved for a Home Equity Loan
Check your credit score before looking for lenders and loan terms. A home equity loan will require a credit score of at least 680. 6 A higher score is preferable. If you don't meet the minimum requirement, you won't be able to qualify for either type of loan until you improve your credit score. You must determine your ability to repay the loan. This includes providing your credit history, household income, expenses, debts, and other amounts owed. The loan-to-value (LTV) ratio of your property is another factor that lenders consider when approving you for a home equity loan or HELOC. It's usually best to keep at least 20% equity in your home, which translates to an LTV of at least 80%, but some lenders allow larger loans.Important Takeaways:
- Home equity is a homeowner's ownership interest in their home.
- It may rise in value over time if property values rise or as you pay down your mortgage loan balance.
- You can calculate your equity by taking the current value of your home and subtracting the amounts owed on any mortgages or other liens.
- There are steps you can take to increase the value of your home.
- You can borrow money against the equity in your home, but this is risky because your home serves as collateral for the loan.
