If you’re interested in homeownership, “home equity” might be one of those home buying terms that you come across a lot without being entirely sure what it means.
- What Is Home Equity?
- How Does Home Equity Work?
- What is Home Equity Used For?
- How to Borrow Against Home Equity
- 5 Tips for Building Home Equity in a Home
- Building Home Equity is a Good Thing
We get it – new homeownership can be a dizzying topic, and there’s lots to keep track of.
But home equity is one of the most important concepts to grasp when buying a new home, and one of the fundamental pluses of home ownership: Unlike a home you rent, a home you buy can actually pay you back.
How is that? Well, the reason for that is home equity, and we’re here to explain what it’s all about!
What Is Home Equity?
The basic definition of home equity is simple: Home equity is the value of your share in a home.
Okay, so what’s your share in a home?
That’s simple, too. Unless you bought your home with a big bag of cash, you’ve probably taken out a home loan which means that you own some of the home, and your lender owns some.
As you pay off the mortgage, you gradually own more and more, while your lender gradually owes less and less.
If you think of your home as a pie, your slice of the pie gradually gets bigger, while your lender’s piece gets smaller. Home equity is the value of your piece of pie.
How Does Home Equity Work?
Home equity can be expressed as either a percentage or a cash value.
To return to the bag of cash example, anyone who buys their home outright immediately owns the whole home, so they have 100% equity. If that home has a market value of $400,000, you could also say they have $400,000 equity. Both numbers refer to the same piece of pie.
How to Calculate Home Equity
Of course, most people don’t buy their homes outright.
Say you buy that same $400,000 home by putting down a 10% down payment, and taking out a home loan for the remaining $360,000. As soon as you buy the home, you immediately have 10% (or $40,000) equity in your home, and that number goes up as you make mortgage payments.
At any point in time, you can always calculate the cash value of your equity by taking your home’s estimated current market value, and subtracting the amount you still owe on your mortgage:
Home’s market value – the amount you still owe on the home = your equity in the home.
The formula above will give you the cash value of your current home equity. If you want to know your equity in the form of a percentage, simply divide that cash value number by your home’s current market value.
Let’s look at an example. After a few years of regular mortgage payments, you now owe less money to your lender: Excluding interest, you’ve paid off $80,000 of your home, on top of your original $40,000 down payment. You’ve now paid off a total of $120,000, and you still owe $280,000.
If your home’s market value has held stable at $400,000, that means:
$400,000 market value – $280,000 still owed = $120,000 in home equity
If you want the equity as a percentage, divide that home equity cash value by the current market value of your home:
$120,000 in equity ÷ $400,000 market value = 30% equity.
So if someone were to cut up that home pie today, your slice would be 30% of the pie, and it would be worth $120,000 on the pie market. Your lender’s slice, now 70% of the pie, would be priced at $280,000. (It’s an expensive pie.)
Can Home Equity Change?
Home equity certainly can, and does, change.
As we just saw, you’ll increase your home equity just by making your monthly mortgage payments, because you’re owning more and more of the home. But your home equity can also change (for better or worse) if the market value of your home changes.
Let’s look at two examples.
i. Home Equity Increase
We’ll return to our $400,000 home. You’ve paid off $80,000 of the principal with monthly payments over the last few years, plus your original $40,000 down payment, so that you’ve paid $120,000. You still owe $280,000.
You can get a rough estimate of your home’s value by looking around at current prices of similar homes in your area, and find that – due to market conditions and other factors – your home’s value has probably gone up (though if you want to actually use your home equity, you’ll need to get a professional appraisal). You estimate that your home is now worth about $440,000.
If you do the same calculation we did above, you’ll get your estimated equity:
$440,000 market value – $280,000 still owed = $160,000 in home equity.
$160,000 home equity ÷ $440,000 market value = 36% equity.
Because your home has become more valuable, your stake in your home is now worth $160,000 instead of $120,000. You effectively earned $40,000 without having to do anything. You also have a higher equity percentage – 36% – instead of the 30% you’d have had if the home price hadn’t changed.
The key is to remember that the market value of your home could change, but the amount of your original home loan will not: If you took out a $360,000 mortgage, the principal you have to pay back will stay $360,000, even if your home is eventually worth $4 million instead of $400,000.
This makes home ownership a very smart and easy way to build wealth. As to what you can do with that increased value, we’ll get into it more below. But first….
ii. Home Equity Decrease
Unfortunately, the same thing can happen in reverse.
We’ll use the same example, in which you’ve bought a $400,000 home, paid off $120,000, and owe $280,000 on your mortgage. But this time, the home’s value has decreased, and it’s now worth $360,000.
If we do the same calculation, we’ll find:
$360,000 market value – $280,000 still owed = $80,000 home equity
$80,000 home equity ÷ $360,000 market value = 22% equity.
Even though you’ve paid $120,000 towards owning your home, your share of that home is currently worth $40,000 less than you paid for it. Your equity percentage has also gone down: You own 22% of the home, instead of the 30% you’d have owned if the home price had remained stable.
Of course, any home equity calculation is essentially a snapshot in time. If your home price has dropped for now, it can always go back up. This is just one reason why it’s important to be as flexible as possible with your timing if you plan to sell your home, or to use your home equity, so that your share is worth as much as possible.
What is Home Equity Used For?
We’ll get more into the weeds of home equity borrowing below, but for now let’s just say that your home equity can help you get a low-interest loan – and that the more equity you have, the more you can borrow.
There’s a wide range of ways to use home equity.
Canceling Private Mortgage Insurance (PMI)
If you took out a conventional loan and put down a down payment of less than 20%, your lender likely bundled private mortgage insurance (PMI) payments into your monthly mortgage payments. PMI ranges from 0.3% and 1.5% of the loan value, which may not sound like much, but it can add up: A homeowner with a $360,000 mortgage could expect to pay about $100-$250 per month in PMI, or $1,200 – $3,000 per year.
The good news is, as soon as you reach 20% equity in your home, you no longer have to pay PMI. Your lender will cancel the PMI requirement automatically once you reach 22% equity in accordance with your regular payment schedule – but you can request for it to be canceled as soon as you hit 20%.
If you believe you’ve hit the 20% target amount ahead of schedule– say, if the sales prices of homes in your neighborhood are going up and you believe your home is worth more than it originally was – you can tell your lender. They’ll want the home professionally appraised, and if it’s determined that you have indeed reached 20% equity, you’ll no longer have to pay PMI.
Another common use of home equity is to make home improvements. Not only do home equity loans typically offer a lower interest rate than credit card or personal loans (more on that below) – the interest on those loans is often tax-deductible, if you’ve used the funds to improve the value of your home. Which can, in turn, also cause your home to be worth more, increasing your equity – making this a very financially savvy move.
College tuition payments and expenses are another common use for home equity, as the interest rates are typically less than those on student loans, or personal loans. It can also be a good way to consolidate student loan debt into one payment.
Consolidate High Interest Debts
The same thing goes for pretty much any type of debt. With that all-important low interest rate, home equity loans are a smart way to consolidate debt like credit cards, car payments, and personal loans into one monthly payment; by taking out a low-interest home equity loan to pay off all those other debts, you’ll just have the one monthly payment on your home equity loan, instead of a bunch of separate ones. It’s not only a convenient way to organize your finances, but can also save you a bundle in lower interest payments.
How to Borrow Against Home Equity
If you want to tap into your home equity, you’ll need to get your home professionally appraised. As we mentioned earlier, you can get a rough idea of its current market value by checking the sales prices of similarly-sized homes in your neighborhood, but if you want to take out money, it will have to be based on more than an estimate. This is one reason why borrowing against home equity can take longer than other loan options.
Another key component of home equity borrowing, as we’ve mentioned, is the comparatively low interest rates; you might find yourself paying 4%-6% interest on a home equity loan, as opposed to 15% on a personal interest loan and close to 20% on a credit card.
That said, it’s crucial to remember the reason for those low interest rates: unlike unsecured debt like credit cards or personal loan payments, borrowing money based on the value of your home means that you’re putting your home up as collateral. Which means that if you’re unable to make payments, your lender could seize your home. This is one reason why borrowing against your home equity – just like any other kind of borrowing – should be carefully considered.
a. Home Equity Loan
Home equity loans, also referred to as second mortgages, are in many ways like any other type of loan: You apply for a set amount, which you agree to pay back on a predetermined timeline, with a fixed interest rate and fixed payment amounts. Once you agree to the loan, you receive all the funds at once in a lump sum.
The amount of equity you have in your home directly affects how much you’re able to borrow. First, lenders usually require you to have 15-20% equity in your home to qualify for a home equity loan of any amount. Next, the amount of equity you have determines how much you’re eligible to borrow, when determining the combined loan-to-value (CLTV) ratio – which essentially means the maximum amount of money the lender might be willing to offer you.
Generally speaking, a lender could offer you as much as 80%-90% of your current home equity – so if you have higher equity, you may be eligible for a bigger loan. But it’s important to remember that this figure is a ceiling: a lender may well offer less than that, depending on factors like your income and credit score. These will also play into what kind of rate you’re offered.
Almost everything we’ve said about home equity loans also applies to home equity lines of credit (HELOC). The key difference is the way the funds are disbursed. Whereas a home equity loan will provide you with a lump sum all at once, HELOCs function more like a credit card, where you have a maximum amount that you could theoretically borrow, but you only take out as much as you need at any given time, and your monthly bill depends on how much you’ve taken out.
But unlike a credit card, though, which requires you to start repaying your balance almost immediately, HELOCs can have “draw periods” of up to 10 years, during which you only have to make interest payments on what you’ve borrowed, and don’t have to make larger payments on the principal yet. This could save you a lot of money in the short term, but you’ll need to keep in mind that you have higher payments waiting for you down the road – and the more you take out (and the less you pay back), the higher they’ll be.
Interest rates for HELOCs are typically variable-rate, and can change as often as month-to-month, so that your payment amount fluctuates with the market. This brings all the same risks as an adjustable-rate mortgage – your interest rate could fall, or it could rise – so this option is best for someone comfortable with a certain amount of risk.
c. Fixed-Rate HELOC
While most HELOCs are automatically variable-rate, some lenders will offer a fixed-rate option. This is exactly what it sounds like: Rather than an interest rate that could change repeatedly, a fixed-rate HELOC offers you fixed monthly payments. If you prefer to avoid uncertainty, a fixed-rate HELOC could be for you. They often have a longer payoff period than variable rates. Deciding on which type of HELOC you want is basically making the same decision you made on a fixed-rate or adjustable-rate mortgage.
d. Reverse Mortgage
A reverse mortgage is typically for homeowners 62 and older, who’ve already paid off their mortgage and want to keep living in their home as their primary residence. In this model, they receive regular payments from their home equity rather than the reverse.
Say a 65-year-old homeowner has paid off their mortgage, and therefore has 100% equity in a home worth $500,000 (or in other words, they have $500,000 equity). A reverse mortgage allows this homeowner to turn their home equity into regular cash payments, almost like a paycheck – though it’s key to remember that this is still money being borrowed, which will need to be paid back. If you wanted to put $500,000 directly into your bank account, you’d need to sell your home, hope for a good price, and find a new place to live.
There are no fees associated with reverse mortgages, though you will still be responsible for homeowner’s insurance and property taxes. Reverse mortgages also don’t require any payments until the homeowner moves, sells, or passes away (in which case the homeowner’s co-borrower, or heirs, will have to pay back the amount the homeowner borrowed).
e. Cash-Out Refinance
A cash-out refinance is something in between a home equity loan and a reverse mortgage payment. If you still want to live in your home while tapping into your equity – and if you want to start paying it back right away – a cash-out refinance could be for you.
We return to our old friend, the $400,000 home. Now some more time has passed, and you’ve paid off $120,000 of the home, plus your original $40,000 down payment. You now owe $140,000 on your original mortgage. Your home’s value has also gone up, from $400,000 to $480,000.
Even though you now “only” owe $140,000, you can take out a new mortgage for the total amount your home is now worth – so you could take out a new mortgage of $480,000, put aside $140,000 to pay off your first mortgage, and keep the remaining $340,000 for whatever you want. This can be an excellent way to meet other financial goals, like student loan payments, home renovations, or paying off high-interest debt, but how you spend it is up to you. Better yet, the money you cash out is also tax-free.
6. 5 Tips for Building Home Equity in a Home
This might all sound great – but how do you build up home equity? There are lots of ways to boost your home equity, but here are a few of the top methods.
1. A Larger Down Payment
This one might seem a little obvious – but put down as large a down payment as possible when you buy your home. The larger your down payment, the higher percentage of the home you’ll own as soon as you close on it, so you have a higher floor to work from.
2. Consistent Mortgage Payments
Here’s another easy one – make consistent, on-time mortgage payments, for as much as you can comfortably afford (ideally higher than your minimum required payment). The more you pay every month, the more of your home you’ll own, and the sooner it will be paid off.
3. Refinance to a Shorter-Term Loan:
Again, if you can afford it, consider speeding up the mortgage payment process by refinancing to a shorter loan term. You’ll not only pay the loan off sooner – you may be offered a better interest rate, and could save money by avoiding interest payments that would have accrued with a longer loan.
4. Look Into Home Improvements That Could Improve Your Home’s Value
Like remodeling the kitchen or bathroom, replacing exterior siding, improving the home’s energy efficiency, or replacing the garage door. Keep in mind that home renovations don’t automatically add value to your home, so you’ll need to research which ones will pay (though of course, any renovations can still be worth it for you personally – after all, it’s your home!).
5. The Last One Is Maybe The Easiest of All:
Just stay put. While you can sell your home at any time, the longer you live in your home, the more chance you’ll have of seeing its market value increase, along with your equity.
Building Home Equity is a Good Thing
With any luck, the idea of home equity is making a bit more sense at this point. It might also be more clear why renting is in some ways equivalent to throwing money down a sinkhole – because no matter how many payments you make, you owe the same amount of money every month (if you’re lucky), and you’re getting no closer to owning your rental home or apartment.
Mortgage payments, on the other hand, are more like lovingly placing that money in a safe deposit box, which home equity gives you the ability to open.
At K. Hovnanian Homes, with meticulous attention to detail and excellent customer service, we take pride in building beautiful new construction homes and communities across the nations – with a wide offering of homes and designs, you can be sure to find a new home to fit both your lifestyle and your budget.
Last Updated on November 16, 2023