What is home equity and how to use it?

 Key takeaways

• Home equity is the amount you own entirely, not money owed to the mortgage company.

• Home equity is mostly built through down payments and mortgage repayments. Increased property value and home modifications can boost ownership equity.

• Utilize equity for various purposes through loans and HELOCs. • Home equity financing has risks and costs, despite favorable interest rates and tax benefits.

 

You may feel that your home is yours. It doesn't if you bought it with a mortgage. The lender that provided the funds owns part of it. In financial terms, “equity” means “ownership” of your home.

Home equity represents your economic stake in your home. Your mortgage debt minus your house equity: In summary, this is your equity. Non-static quantity. Paying down your mortgage increases equity. Your home's value can rise with real estate values or if you make major modifications.

Home equity may be a cash cow as well as an estate asset. How equity works and how to use it.

What is home equity and how does it work?

Home equity is your ownership stake in your home, not the lender's. It represents the percentage of your home you purchased for in cash (via your down payment) and have paid off in monthly mortgage payments. Home equity is your home's appraised value minus your mortgage and debt balances. Equity will grow if your home doesn't depreciate and you make on-time payments.

Home equity calculation

Follow these steps to determine home equity:

1. Determine the approximate market worth of your home. Your home may be worth less than it was a few years ago or last year. A local real estate agent or professional appraiser can help you determine your house's market value better than internet home price estimators.

2. Subtract mortgage balance. Check your latest mortgage statement after determining your home's market worth. Subtract your mortgage and any home-secured loans. The result is home equity.

How to boost home equity

Home equity is the difference between your home's market worth and your mortgage balance, so it can rise in several ways.

Mortgage payments

Reducing your mortgage is the easiest approach to boost home equity. Your monthly mortgage payment reduces your debt and increases your home equity. You can also accelerate equity growth by paying more mortgage principal.

Home renovations raise property value.

Even if your mortgage principal balance stays the same, home equity builds as property value rises. Remember that certain house renovations offer more value than others. installing another bedroom, which has broad appeal and a range of functions, is more likely to improve your home's sale price than installing a hot tub, which requires expensive care that many people may not want.

When property values rise

Many property values rise with time. Appreciation might help you develop equity. It's impossible to predict how long you'll have to stay in your home to see a substantial value increase because location and the economy affect it. The historical price data of homes in your neighborhood may indicate whether values are rising or falling.

A big down payment

How much you paid for your new house determines your initial equity share. Putting down 20% vs 10% when you buy a property instantly increases your equity. You may also tap equity faster.

Home equity access methods

Home equity loans

Home equity loans are secured by property. They're called second mortgages because they work like your original mortgage, which you used to buy the home.

The lender pays a flat payment when you get a home equity loan. After receiving your loan, you repay it immediately at a predetermined rate. That implies you'll pay a set sum each month throughout the loan's five or 30 years.

If you have a huge, immediate expense or multiple debts or loans to pay off, this is best. Predictable monthly payments are included.

Home equity loan interest for major remodels or repairs may be tax-deductible.

Home equity lines of credit

Home equity lines of credit (HELOCs) are secured by your home and act like credit cards.

Initial draw periods, usually up to 10 years, allow unlimited withdrawals up to the credit limit. As you pay down the HELOC principal, the credit line rises and can be used again, like a credit card. This allows you to access cash as needed.

Variable rates on most HELOCs mean your monthly payment can change over time. Fixed-rate HELOCs feature higher starting interest rates and fees from some lenders. Interest-only or interest-principal payments are also options. The latter accelerates loan repayment.

Interest and principal are due after the draw period. Ten to twenty years are typical repayment lengths. A HELOC utilized for a major home repair project may be tax-deductible.

Cash-out refinance

A cash-out refinance swaps your mortgage with a larger one. This loan includes your mortgage debt and a percentage of your home's equity removed as cash. Use these dollars whichever you like. Based on market conditions, a cash-out refi may cut your main mortgage rate and shorten the term so you may repay it sooner than a HELOC or home equity loan.

The reverse mortgage

Another approach to tap home equity is a reverse mortgage for persons 62 and older (or 55 with some programs). Unlike a HELOC or home equity loan, a reverse mortgage doesn't require monthly payments. Instead, the lender pays you monthly while you live in the home. Death, permanent eviction, or property sale require repayment of the loan and interest.

Equity share agreement

Professional investors (or investment companies) and homeowners sign a shared equity agreement. You can get a lump sum of cash for a percentage of ownership in your house and/or its potential appreciation. The investor is paid when the agreement ends or when you sell the home. You don't pay monthly yet. These agreements serve credit-challenged borrowers or individuals with financial problems that impede typical loans.

Leveraging home equity

You can do almost anything with your ownership stake. Common equity leverage methods for homeowners are listed below.

How to use home equity

Cancel your private mortgage insurance (PMI): A low-down-payment mortgage may require monthly private mortgage insurance (PMI) to decrease your lender's risk of default. Many loans allow you to remove mortgage insurance after 20% equity. Refinancing works nicely if your home has appreciated since your original mortgage. Refinancing is the only way to remove mortgage insurance from recent FHA loans without a 10% down payment.

• Resolve outstanding balances: Your home equity loan or line of credit might consolidate high-interest debt, especially credit cards. This often reduces outstanding debt faster. Mortgage debt is deemed “good” because it helps you buy a valued item, but credit card debt gets you nothing and lowers your credit score.

• Homeowners may use home equity loans to pay for college tuition or establish a business, instead of student or parent loans. The terms of secured debt are usually better than unsecured finance. If starting a side business, home equity loans may be better than business loans.

• Use equity to finance home upgrades, increasing equity further. Rehabs and repairs are typical applications of home equity lending because the interest is tax-deductible. Upgrades that save energy qualify for tax benefits.

Borrowing against home equity pros and drawbacks

Before applying for a loan or line of credit, evaluate the pros and downsides of borrowing against home equity.

Pros

• Home equity loans and lines of credit have lower interest rates due to the collateral used, making them less risky than other lending options. These products have better rates than unsecured credit cards or personal loans.

• Flexible use: Lenders do not limit spending on home equity loans or HELOCs. You can spend the money however you like.

• Homeowners can deduct interest on home equity loans or lines of credit if they itemize on their tax returns and utilize the funds to “buy, build or substantially improve” their property.

Cons

• The cost of borrowing: Home equity loans or HELOCs frequently need closing charges like a mortgage. As you compare lenders, pay attention to the APR, which covers interest and other expenses. Rolling these expenses into your loan may increase your interest rate.

• Home loss risk: Home equity debt is secured by your home, so your lender can foreclose if you default. If property values fall, you may owe more than it's worth. That may make selling your home harder.

• Use home equity for investments, such as house renovations, business startup, or debt elimination. Do not hock your house for discretionary products or events. Choose needs over wants to avoid living over your means.

• Adjustable rates pose a risk of surprise interest increases, leading to higher payments for most lines of credit and loans. Especially HELOCs: Paying interest and principle can be overwhelming when you reach your repayment period.