What Is Home Equity?

What Is Home Equity?

Home equity is the difference between your home's value and how much you still owe on your mortgage loan. When you buy a home with a mortgage, you share ownership with your lender until the loan is fully repaid. Your equity represents how much of your home you actually own.

If you provide a down payment when you get a loan to buy a home, that amount is your initial equity in the home. Your equity grows as you make monthly mortgage payments and, ideally, your home's value increases.

How Does Home Equity Work?

You build equity in your home in a few ways. If you take out a mortgage and provide a down payment, that's your first bit of equity. The larger your down payment, the more equity you have at the start of your mortgage term (and the less interest you'll pay over the life of the loan).

Then, as you make monthly mortgage payments and start reducing your principal, your equity in the property increases. Additionally, if your house value increases through appreciation or home improvements, your equity grows.

Home equity can be an important asset—even one you can borrow against if need be. Additionally, equity makes it possible to make down payment money back, possibly with profit, when the home is sold.

Borrowers who put down less than 20% on conventional loans are often required to pay for mortgage insurance as part of their monthly payment. This protects the lender should the borrower be unable to repay the loan. Typically, PMI can be canceled once 20% equity is achieved, but the ongoing expense up until that point can add up. As a result, some buyers may choose to save for a larger down payment so they can avoid paying PMI and start off with more equity in their home.

How to Calculate Your Home Equity

Calculating your home equity involves some quick math. First, find out your home's current value, either from your latest tax assessment or from a real estate website estimate.

To calculate your home equity, subtract what you owe on your mortgage from your home's market value. That difference indicates the dollar amount of equity you have in the property.

If you want to view it as a percentage, use this formula below.

Home equity formula:

Example: Let's assume your home's current value is $300,000, and you have $240,000 left to pay on your mortgage.

1. Find the current value of your home. You can do this with a formal appraisal or by using estimation services provided for free from real estate websites including Zillow and Redfin. In the example above, that's $300,000.
2. Find the remaining balance on your mortgage. Your mortgage statement will show how much of your principal balance you have left to pay. In the example above, that's $240,000.

3. Calculate the dollar amount of your equity. To find this, you'll subtract your mortgage balance from your home's current value, like this:

   • $300,000 - $240,000 = $60,000

4. Convert to a percentage. Next, you'll take the amount you've paid off and divide it by your home's current value, then multiply by 100, like this:

   • ($60,000 / $300,000) x 100 = 20% equity

The remaining amount is your equity stake in the home. This is especially useful to know if you have private mortgage insurance (PMI) that you can cancel after building a certain percentage of equity in the home (typically 20%).

How to Increase Home Equity

If you want to ramp up your equity stake in your home, here are some options:

• Pay more upfront. When you make a larger-than-required down payment on a mortgage, you enter homeownership with more equity. This means making more money back if you sell, and it leaves you with less debt to repay. As an added bonus, some lenders offer lower interest rates for larger down payments.
• Make investments in your property. Certain home improvements can boost your home's value, meaning you could sell the house at a higher price tag. That added value also counts as equity. Examples of value-boosting improvements include updating the kitchen, adding a bathroom or garage, redoing landscaping, getting a swimming pool or putting in new floors. Be aware, though, that upgrades can be expensive, so research which improvements offer the best return on investment.
• Repay your mortgage faster. Whenever you can afford it, pay more than you owe on your mortgage, or make biweekly payments instead of monthly. The faster you pay down your loan, the quicker you'll accumulate equity. Just make sure to check first if your lender has any restrictions or prepayment penalties or lender restrictions on payments.
• Let the home appreciate. If your home is in a growing or popular area, home prices will likely rise over time, even without making improvements. This passive appreciation means you don't do anything, though you can't predict or control how much—or when—it will happen. The other side of the coin is that this might mean higher property tax bills.

Learn more: Ways to Quickly Build Home Equity

How to Use Home Equity

One of the perks of home equity is you can tap into it, whether you need money to make home improvements or tackle a large cost. You can't borrow against all of it, however, since that's too risky for lenders. After all, they are also invested in your property until you've repaid your loan.

Home Equity Loan

Also called a second mortgage, a home equity loan provides a lump sum which you repay in fixed installments over a set term (often five to 30 years). It's ideal for those who need money for a major one-time expense, such as a home addition. Lenders often allow you to borrow a large amount of your home's equity, though this can put your home at risk if you can't keep up with payments.

Home Equity Line of Credit

Rather than providing you a lump sum to repay over time, a home equity line of credit (HELOC) offers a revolving line of credit you can borrow from again and again as you pay down the balance. You can usually borrow up to 85% of your home's equity with a HELOC.

HELOCs have a draw period, usually 10 years, during which you can borrow up to your credit line and only pay interest on what you've borrowed. When the draw period ends, you can no longer borrow and have to pay the HELOC back in full (usually over 10 to 20 years).

Cash-Out Refinance

Using a cash-out refinance entails refinancing your mortgage for more than you owe and pocketing the difference as cash. While it can help you utilize your home equity, it does require taking out a new mortgage loan to replace your old one and causes your new mortgage balance to be higher. Lenders usually allow borrowing up to 80% of the home's value in a cash-out refinance.

Reverse Mortgage

A reverse mortgage is an option for homeowners 62 years of age or older who own their homes outright or have substantial equity. This unique type of loan allows you to borrow against your home, but you don't repay it as long as you remain in the home.

With a reverse mortgage, you decide how you want the funds to be disbursed. The choices are usually:

• Lump sum
• Line of credit
• Fixed monthly payments

The lender gets their money back from your equity if you sell the home and move, die or become delinquent on other costs such as property taxes or insurance. Research lenders carefully, as some companies may try to take advantage of vulnerable borrowers who are older or at risk of foreclosure.

Pros and Cons of Using Home Equity

Like many financial choices, the concept of tapping your home equity isn't inherently a good or bad idea. Carefully review your personal and financial circumstances, and take time to understand the pros and cons in order to make an informed decision.

Learn more:Should You Tap Into Your Home Equity?

Should I Use Home Equity?

Whether or not you should use home equity depends on a number of factors, including the potential use and your broader financial situation.

Pay With Savings When Possible

When facing a major expense, it's typically best to aim to pay with savings first (or wait until you can build up the savings or will receive a windfall like a tax return). Taking on debt is a risk; it costs you more money due to interest and it can hurt your credit if you make late payments or miss any.

Plus, home equity isn't something you have to use; it's just an available option. If you're considering tapping your home equity, it's important to ensure the benefits are worth it compared to other options, and that you understand that your home is at risk should you be unable to repay.

Best Uses for Home Equity

Home equity is best used in situations such as:

• Financing home renovations that will add back value
• Making emergency home repairs, like an HVAC system that's gone out
• Preparing your home for sale
• Paying for large, unexpected costs such as medical bills that would otherwise require you to take on higher-interest debt
• Paying for educational expenses if you've already maxed out on federal loans
• Consolidating high-interest loans or credit cards

When should you not use home equity? You should typically avoid using it for discretionary purchases like a vacation or shopping.

Learn more: Reasons Not to Tap Into Home Equity

The Bottom Line

When you buy a home, you can start building equity in a range of ways, from repaying your mortgage faster to adding value through property improvements.

When you apply to borrow against your home equity, you will also undergo a credit check, since lenders want to ensure borrowers are likely to repay—even with your house as collateral. Check your FICO^® Score^Θ for free from Experian before you apply to make sure you're ready.