What is Home Equity?“Home equity” refers to the portion of your home's value that you own outright.
When you purchased your home, you put forth a downpayment and took out a mortgage. Each month, you make a payment against that mortgage, so that over time you have chipped away at it. The so-called “equity” represents the difference between the current market value of your home and the outstanding balance of your mortgage. Any other debts that are secured by your home also detract from your equity.
How to Calculate Equity in a HomeThink of it like an equation:
Home Equity = Current Market Value of Home - Mortgage Balance(s) - Other Liens
Let’s describe each component:
Current Market Value of Home: This is the estimated value of your home in the current real estate market. It can change over time due to factors like local real estate trends, any renovations you undertake, or basic economic conditions. Appraisals or comparative market analyses can help determine your home's current value (and most lenders will order them).
Mortgage Balance(s): This represents the amount you still owe on your mortgage loan(s). It includes both the principal balance (the original loan amount) and any accrued interest. As we stated above, when you make mortgage payments over time, the principal balance decreases, which increases your home equity.
Other Liens: In some cases, homeowners may have other liens or loans secured by their property, such as home equity lines of credit (HELOCs), or second mortgages. These outstanding balances are subtracted from your home's value to calculate your net home equity.
How to Build Home EquityAs we can deduce from the above equation, building home equity simply entails increasing the value of your home and reducing the amount you owe on your mortgage. Over time, as both you make mortgage payments and your home's value appreciates, your home equity grows.
There are some strategies you can employ to build your home equity:
- Make Regular Mortgage Payments: You should be doing this anyway, but consistently make your monthly mortgage payments. A portion of each payment goes toward reducing the principal balance, which increases your equity.
- Choose a Shorter Loan Term:Consider a shorter loan term, such as a 15-year mortgage, instead of a 30-year mortgage. While monthly payments may be higher, you'll build equity faster and pay less in interest over the life of the loan.
Make Extra Payments:Make additional payments toward the principal balance of your mortgage. Even small extra payments will add up over time and thus accelerate your equity growth.
- Refinance to a Lower Interest Rate: Have interest rates dropped since you obtained your mortgage? Consider refinancing to a lower rate! This can lower your monthly payments and enable you to allocate more funds toward reducing the principal balance.
Make Home Improvements:Invest in home improvements and renovations that increase your property's value. Some examples might be kitchen and bathroom upgrades, energy-efficient improvements, or landscaping enhancements.
- Maintain Your Home: As a responsible homeowner, you should already regularly maintain and repair your home to prevent depreciation. However, in addition, addressing issues promptly can help maintain or increase your property's value.
- Avoid High-Interest Debt:Minimize high-interest debt–like credit card balances–by paying them off as quickly as possible. This will prevent excessive borrowing and ensure more of your monthly budget goes toward mortgage payments.
- Avoid Second Mortgages or HELOCs for Non-Essential Expenses: While home equity lines of credit (HELOCs) and second mortgages can be useful, avoid using them for non-essential expenses or lifestyle upgrades. It is a much better strategy to use home equity for investments or major home improvements that add value.
Make a Larger Down Payment:When purchasing a home, consider making a larger down payment. The larger the down payment, the more equity in the property from the beginning.
- Monitor Property Values: Monitor local real estate market trends and your property's value. Property appreciation can have a huge impact on your home equity.
- Avoid High-Risk Loans: Be cautious about high-risk loan products, such as interest-only mortgages or adjustable-rate mortgages (ARMs); they can make it harder to build equity.
How To Use Your Home EquityYour home equity can be a powerful financial tool, and there are multiple situations where it might be practical to wield it.
Cancel Private Mortgage Insurance (PMI)
As you may recall, PMI is typically required when the borrower's down payment is less than 20% of the home's purchase price (or appraised value). It's an additional cost that is meant to protect the lender in case the borrower defaults on the loan. The homeowner makes monthly PMI payments as well as the regular mortgage payments.
One key aspect to canceling PMI is your loan-to-value ratio (LTV). This is because federal law requires automatic termination of PMI once the LTV ratio reaches 78%, but some lenders may allow cancellation at 80% or even sooner if certain conditions are met. To determine your LTV, divide your mortgage balance by the current market value of your home. For example, if you owe $150,000 on your mortgage, and your home is appraised at $200,000, your LTV ratio is 75% (150,000 / 200,000).
Make Home Improvements
Do you have an unfinished basement that has been driving you mad with its wasted potential? Perhaps you’ve been dying to open up your kitchen into the dining room to make the most of your main floor? Or, is your bathroom still stuck in 1960? If you tap into your home equity, the cash you receive can be used for these renovations–and other home improvements that you might want. Such projects not only make your house a better place for you and your family, but could potentially also increase the value of your home.
Pay For College Tuition
If you’re starting to build a strategy for financing your child’s college education, you’ve probably familiarized yourself with a multitude of options. College is expensive; even with scholarships and grants, most students and their families must seek additional forms of financial aid. Using home equity to pay for college can provide a source of funding with potentially lower interest rates compared to other borrowing options, such as personal loans or credit cards.
Fund Your Big Business Idea
Itching to turn entrepreneur? It’s possible to use your home equity to secure financing–as opposed to personal or business loans. Do your research and see which option has more favorable terms, like fixed or lower interest rates. Just remember, when you use your home equity, you are technically putting your home on the line!
Consolidate High-Interest Debts
Debt can be a weight chained to your ankles that makes it almost impossible to keep your head above water. Credit cards, personal loans, and medical bills are all forms of high-interest debt that can haunt you. If you find yourself dragged down by such debt, you might be able to experience some relief by leveraging your home equity to consolidate–or even eliminate!--it.
Purchase a New Home
This strategy allows you to leverage the equity you've built in your current home to finance the purchase of a new one. It’s always a good idea to consult a financial professional when making a big financial decision; however, in this situation in particular you should meet with a mortgage professional to go over the details of this strategy.
Save for Retirement
Living on a fixed income post-retirement can be really tough; the cost of living rises, but your savings stay the same. Diversifying your retirement savings across different assets and income streams can help ensure financial stability in retirement, and tapping into your equity can be a strategic component. This is especially true if you’re desirous of aging-in-place and feel that you will need to make some home improvements in order to enable you to stay in your home.
How to Take Equity Out of Your Home
A cash-out refinance is a mortgage refinancing option in which a homeowner replaces their existing mortgage with a new one–that has a higher loan amount, and often potentially better terms. Then the homeowner receives the difference between the two loan amounts in cash. So in other words, it allows you to "cash out" a portion of your home's equity in the form of a lump-sum payment while simultaneously refinancing your mortgage. Bear in mind, though, that undertaking a cash-out refinance will reset the clock on your mortgage repayment, and increase the mortgage balance.
Home Equity Loan
A home equity loan is a loan that uses your home equity as collateral. Since you’re staking your home, the terms tend to be better than a pure personal home, as lenders feel that it is more secure. It is often referred to as a “second mortgage.” It’s important to note that a home equity loan adds an additional monthly payment to your financial obligations, and may come with a variable interest rate that would make it very difficult to make an accurate financial plan for the future.
Home Equity Line of Credit (HELOC)
A HELOC is a revolving line of credit–rather like a credit card–where borrowers can access funds as needed up to a predetermined credit limit. Once again, your home’s equity is the collateral for the loan. Traditionally, HELOCs have two phases: the draw period, during which you can access the funds and, often, make interest-only payments, and the repayment period, which is when you stop using the funds and must repay that which you’ve spent as well as the accumulated interest. HELOCs offer flexibility and convenience for accessing funds when needed, but they are also frequently accompanied by variable interest rates that can lead to increasing monthly payments, and the potential for overspending or accumulating high-interest debt.
A reverse mortgage, designed specifically for homeowners aged 62 or older, allows the homeowner to convert a portion of their home's equity into tax-free cash without having to sell their home, give up ownership, or make monthly mortgage payments. Instead of monthly payments, the loan is typically repaid when the homeowner moves out of the home, sells the home, or passes away. At that point, the loan balance, including accumulated interest and fees, is settled by selling the home, with any remaining equity belonging to the homeowner or their heirs.There are multiple disbursement options, such as: a lump sum payment, a credit line to be drawn from as-needed, regular monthly payments, or even a combination of these. Of course, this option is only available to those who are over 62 years of age.
Home Equity Sharing Agreement
In an equity sharing agreement, the homeowner trades a portion of their home's equity to an investor or partner in exchange for an upfront cash payment. This arrangement is designed to provide homeowners with access to cash while allowing investors to share in any potential future appreciation of the home's value. With Unison, for example, homeowners can access up to 15% of their home’s current value in exchange for an agreed-upon percentage of the home’s future change in value, and never make monthly payments, or accumulate any interest. Instead of living in fear of potential foreclosure, homeowners enjoy a relationship with the Unison Home Partnership Team, who are there to help them through any difficulties they may encounter throughout the term of the agreement. An equity sharing agreement is a loan alternative that could be a great fit for you if you don’t want to deal with the burden of monthly payments, or worry about changing interest rates. You can get a free estimate from Unison with no effect on your credit, and no obligation, here.