What is Home Equity and How Does it Work

What is Home Equity and How Does it Work

The value of a homeowner’s interest in a home is known as home equity. It may rise over time if the value of the home rises or as you pay off your mortgage loan.

The value of your interest in your home is known as home equity. It may rise over time if the value of your home rises or as you reduce the size of your mortgage debt.

Definition and Example of Home Equity

Your house’s current value serves as the foundation for home equity. Subtract the outstanding balances on any mortgages or other debts you have on the property at this point. These may be second mortgages that were obtained later or purchase loans that you used to acquire the home. The difference is the equity in your home.

Say the value of your house is $300,000. Your home equity is $100,000 if your mortgage has $200,000 left to be paid.

Unless you have a shared equity mortgage, which is uncommon, your lender does not own any equity in the property. The house is yours, but it is being held as security for your loan. The way your lender protects its interest is by placing a lien on it.

How Home Equity Works

Suppose you were to spend $200,000 on a home. You put down 20% and get a mortgage loan for the remaining amount of $160,000. Your equity in your property is 20% of its value: You put down $40,000, or 20% of the $200,000 buying price, for the property. Despite being the owner, you only “own” a portion of it worth $40,000 in total.

Imagine that the real estate market booms and your house doubles in value. If the house were now worth $400,000 and you still owed only $160,000, you would own 60% of the equity. Even though the value of your home has improved, your loan debt would stay the same, increasing your home equity along with it.

Divide the loan sum by the market value to determine your equity ownership, then remove the result from 1 to convert the result to a percentage. The formula would be as follows:

  • 160,000 ÷ 400,000 = 0.4
  • 1 - 0.4 = 0.6
  • 0.6 = 60%

 

How Does One Increase Home Equity?

As a homeowner, there are a few actions you may do to boost your home equity.

Pay Off the Loan(s)

As you reduce your debt balances, your equity grows. The majority of mortgages have normal amortizing repayment schedules, which require equal monthly payments for principle and interest. You accrue home equity at a faster pace each year since the principal repayment amount rises with time.

Your payoff date can be calculated using our loan amortization calculator.

If you had an interest-only loan or any other kind of non-amortizing mortgage, you wouldn’t be able to increase your home equity in the same way. In this situation, you might need to make additional payments to lower the debt and raise your equity.

As your home’s value increases, your equity increases. Your home’s worth can be actively increased by undertaking improvement tasks. When the real estate market is strong and expanding, house values increase and you will automatically begin to create home equity.

Accelerated Payments

The idea of “accelerated mortgage payments” is one well-liked strategy for accumulating home equity faster. Over the course of the loan, using this method will result in significant interest savings. It will enable you to pay off the mortgage sooner and increase the value of your home.

The majority of homeowners make 12 payments a year, or one payment per month, toward their mortgage. Instead, if you send your contribution every two weeks and divide your monthly payment into two equal installments, you’ll send 26 payments annually (365 days divided by 14 days). Making 13 monthly payments corresponds to this arrangement.

If you have a $100,000, 30-year conventional mortgage at 5% interest, you would pay $93,256 in interest if you made monthly payments throughout the loan’s term. If you made half the monthly payment every two weeks, the interest would be decreased to $75,489 and the loan would be paid off in 25 years.

You would own your house free and clear five years sooner and save $17,767 in interest payments.

Before you choose to use this strategy, be sure there are no restrictions on making biweekly payments with your lender.

 

How To Use Home Equity

Since home equity is an asset, it contributes to your overall net worth. If necessary, you can take partial or lump-sum withdrawals from your equity, or you can store it all up and leave it to your heirs.

If you decide to spend some of your home equity today, there are a few ways you may make your asset work for you.

Sell Your Home

If and when you decide to move, you can use the sale profits to withdraw the equity you have in the house. If you still owe on any mortgages, you won’t be able to utilize all of the money from your buyer, but you will be able to use your equity to purchase a new property or to increase your savings.

Borrow Against the Equity

A home equity loan, commonly referred to as a “second mortgage,” allows you to borrow money and use it to pay for practically anything. This enables you to access your home equity while you are still a resident. But since building equity is what you should be aiming for as a homeowner, it makes sense to invest that borrowed money in your future rather than just using it now.

Using a home equity loan to cover current costs is dangerous because you run the risk of losing your house if you fall behind on payments and are unable to make up the difference.

Fund Your Retirement

With a reverse mortgage, you can pay down your equity in your golden years. These loans give retirees a source of income. There are no recurring monthly payments required. When you leave the house, the loan is paid back.

These loans, however, are intricate and may cause issues for homeowners and heirs. The rules for reverse mortgages might be intricate. The home must be your principal residence, and you must be at least 62 years old.

Types of Home Equity Loans

The ability to access a sizable sum of money, frequently at a low interest rate, makes home equity loans alluring. Because the loans are backed by the actual estate, they are also rather simple to qualify for. Before taking out a loan against the equity in your house, carefully examine how these loans operate to completely appreciate the potential advantages and hazards.

Lump-Sum Loan

With a lump-sum loan, you can receive the entire amount all at once and pay it back in regular monthly installments. The duration could be as little as five years or as much as 15 years or more.

Even though you’ll have to pay interest on the entire amount, these loans could still be a wise alternative if you need to make a sizable, one-time cash purchase. You might choose to combine high-interest bills like credit card debt or travel expenses. This kind of loan frequently has a fixed interest rate, so there won’t be any unexpected increases in the future, but you’ll probably have to pay closing charges and other fees to obtain the loan.

Home Equity Lines of Credit (HELOCs) Provide Flexibility

You can take money out of a HELOC as you require it. Only the amount you borrow incurs interest payments. As long as your line of credit is still active, you are able to withdraw any sum you require during the “draw period,” just as with a credit card.

HELOCs are frequently helpful for expenses that may be spread out over several years, such as little home improvements, college tuition payments, and helping out family members who may be struggling.

The draw term, which lasts for a set number of years, such as 10 or 12, and during which you must make small payments on your loan, must be completed. After then, you start a payback period where you pay off the entire amount. There can be a sizable balloon payment at the conclusion of the repayment period.

HELOCs frequently have fluctuating interest rates, so you can end yourself paying back a lot more than you anticipated over the course of the loan.

Depending on how you use the loan profits, your interest may be tax-deductible.

Risks of Borrowing Against Home Equity

The fact that the loan is secured by your property is one danger of using home equity. If you are unable to repay the loan for some reason, your lender may sell your foreclosed home to cover your debt. The house would likely not bring the highest or best price because it would be sold quickly. Your financial worries would increase because you would need to relocate with your family.

Avoid buying fancy clothing, big-screen TVs, expensive cars, or anything else that won’t increase the value of your home with your windfall. To spread out the expense by utilizing a credit card with a 0% introductory APR deal, or to save up cash for those delights, is a safer course of action.

How To Qualify for a Home Equity Loan

Before you start looking around for lenders and loan terms, check your credit score. To qualify for a home equity loan, you need most likely to have a credit score of at least 680. Better still is a higher rating. If you can’t reach the minimum criterion, you probably won’t be able to apply for either sort of loan until you improve your credit score.

You must provide proof that you can repay the loan.To do so, you must disclose your credit history, household income, expenses, debts, and any additional sums you owe.

Lenders will also consider your loan-to-value (LTV) ratio when determining your eligibility for a HELOC or home equity loan. It’s often recommended to maintain at least 20% equity in your house, which equates to an LTV of at least 80%, though certain lenders permit larger loans.

Key Takeaways

  • Home equity is the ownership stake in a property.
  • If property values improve or as you reduce the balance of your mortgage debt, it can rise over time.
  • Starting with the present value of your house, you can determine your equity by deducting the sums owed on any mortgages or other liens.
  • You can take steps to increase the equity in your house.
  • Although you can borrow money using the equity in your house as collateral, this can be dangerous.

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