Home Equity And How You Can Use It

Equity can be a powerful tool. Why not tap into it to pay off debt, make home improvements and more? Read our quick guide for everything you need to know about equity and how you can use it to accomplish your goals.

What Is Home Equity?

Home equity is the amount of your home that you actually own. Specifically, equity is the difference between what your home is worth and what you owe your lender. As you make payments on your mortgage, you reduce your principal – the balance of your loan – and you build equity. 

If you still owe money on your mortgage, you only own the percentage of your home that you’ve paid off. Your mortgage lender owns the rest until you pay off your loan.

For example, let’s say you buy a home worth $200,000 with a 20% down payment of $40,000. In this case, you would have $40,000 of equity in your home as soon as you close. With each mortgage payment you make, the balance of your loan decreases, and you build more and more equity (assuming your home value doesn’t decline). When your mortgage is finally 100% paid off, you have 100% equity in your home.

Can The Equity In Your Home Change?

Yes! It can be difficult to calculate exactly how much equity you have in your home because home values are constantly changing. There are two ways you can increase your home equity: you can pay down your principal or wait for your home value to rise.

Pay Down Your Principal

Every time you make a mortgage payment, you gain a little more equity in your home. In the beginning years of your mortgage, you gain equity slowly. This is because most of the money you pay in the first few years of your loan goes toward interest instead of principal.

As you pay down your balance, a higher proportion of your monthly payment goes toward principal instead of interest. This process, called amortization, means that you build equity faster toward the end of your loan term.

If you want to build equity faster in the first few years of your mortgage, you can pay more than your minimum monthly payment. Just tell your lender that the extra money should be applied to your principal. 

Wait For Your Home Value To Rise

Equity is based on the appraised value of your home. The equity you own is equal to how much an appraiser believes your home is worth, minus the balance of your loan. For example, let’s say you bought a $250,000 home with a $200,000 mortgage. A few years later, your home appraises for $300,000 due to a hot housing market. If you’d paid the loan down to $150,000, you’d have $150,000 in home equity.

Unfortunately, this process also works in reverse. If your local housing market takes a turn for the worse and the value of your property decreases, your equity decreases as well. The amount you’d owe on your mortgage wouldn’t change, but your equity in the property would.

How To Calculate Your Home Equity

To calculate your equity, determine how much you still need to pay on your mortgage principal. Your lender will be able to tell you the balance of your loan.

Next, estimate how much your home is worth. To do this, look at the sale prices of similar homes that have sold near you.

To do the calculation, simply subtract your loan balance from your estimated home value.

For example, say you owe $100,000 on your home, and you believe your home is worth $180,000. Simple subtract $100,000 from $180,000. You have an estimated $80,000 in equity in your home.

If you’re thinking about refinancing, it’s important to know that lenders usually require an appraisal to determine the home value and the amount of equity you have. Estimating your home value can give you a rough idea of how much equity you have, but an appraisal is the only way to know for sure.

How Can You Use Your Home Equity?

You can access the equity you’ve built for several different purposes, including lowering your payment, making home improvements, paying tuition and consolidating debts.

Remove Private Mortgage Insurance (PMI)

Though you no longer need a 20% down payment to buy a home with a conventional loan, most lenders require you to purchase private mortgage insurance (PMI) if you don’t put at least 20% down. Despite the fact that the borrower pays for it, PMI only protects the lender. Most homeowners prefer to cancel PMI as soon as possible.

If you have a conventional loan, PMI is automatically canceled once you reach 22% equity in your home according to your regular payment schedule. However, you can request that your lender cancel PMI when you reach 20% home equity.

If you believe you’ve reached 20% equity due to a rise in your home’s value, you can contact your lender to remove PMI as well. In this case, your lender will likely require an appraisal to verify the value of the home.

Make Home Improvements

Do you want to make improvements on your home but don’t have the cash on hand? You can take equity out of your home to cover the costs of renovations, repairs or construction projects.

A cash-out refinance is one way to do this. By financing your renovations using the equity in your home, you’ll be paying for the renovations at a much lower interest rate than if you were to finance them via a credit card or personal loan.

Pay For Tuition

College can be expensive, and student loans aren’t always the lowest-interest way to finance it. You could use your home equity to get cash for tuition or even consolidate existing student loans. You can also use your home equity to cover books and housing costs if you decide to go back to school – it’s a low-interest way to borrow the money you need now.

Consolidate High-Interest Debts

Mortgage interest rates are typically much lower than interest rates for credit cards, auto loans and personal loans. If you have any of these high-interest debts, you could save big by putting your home’s equity to work.

There are a couple of benefits to using your home equity for debt consolidation:

• By paying off your bills with cash from your home, you’ll reduce your debt payments to a single lump sum.

• You’ll save big on interest. Interest rates for credit cards and personal loans commonly exceed 10%, while mortgage interest rates are usually around 4%.

• By using equity to consolidate debt, you could pay less every month to pay off the same amount of money.

How Can You Access Your Home Equity?

There are several ways you can get access to your home equity, whether through a cash-out refinance or home equity loan, home equity line of credit or reverse mortgage.

Cash-Out Refinance

A cash-out refinance allows you to take out your equity by getting a new mortgage with a higher loan amount. You replace your current mortgage with a bigger one and get the difference in cash. Like with any refinance, your new mortgage pays off your old one, so you just have one monthly mortgage payment.

When you do a cash-out refinance, you usually need to leave some equity in the home. The amount you’ll have to leave in depends on the type of loan, but you should expect to leave about 20% equity in the home.  

For example, let’s say your home is worth $200,000 and you owe $100,000 on your mortgage. To take cash out, you need to leave 20% equity ($40,000) in the home. If you were to refinance your home with a new loan amount of $160,000, you’d get to pocket $60,000, minus closing costs and fees.

You can use the money from a cash-out refinance for anything you want. The money is tax-free, and there are no restrictions on how you can use it.

Home Equity Loan

A home equity loan is a second mortgage on your home. It doesn’t replace your current mortgage; instead, it’s a second mortgage with a separate payment. For this reason, home equity loans tend to have higher interest rates than first mortgages.

Like a cash-out refinance, a home equity loan is a secured loan that uses your home equity as collateral. This gives you access to lower interest rates than unsecured loans, like personal loans.

Once you close on your home equity loan, you’ll receive a lump sum payment from your lender, which you’ll make payments on over a predefined loan term.

Lenders rarely allow you to borrow 100% of your home’s equity for a home equity loan. The maximum amount you can borrow varies depending on the lender but is typically between 75% and 90% of the value of the home.

Home Equity Line Of Credit (HELOC)

A home equity line of credit (HELOC) is a lot like a home equity loan in that it’s a second mortgage on your home. The main difference is that you don’t get a lump sum of money upfront. Instead, a HELOC gives you a line of credit that you can draw from when you need it. The credit limit corresponds to the amount of equity you have in your home.

You can withdraw HELOC funds at any time during the draw period defined by your lender. Most draw periods are between 5 and 25 years. HELOCs may have a minimum monthly payment due (similar to a credit card), or you may need to pay off the accrued interest each month. At the end of the draw period, you’ll need to repay the full amount borrowed.

Interest rates on HELOCs are usually based on an index instead of a fixed rate. There are usually no limits on the amount the interest can increase each period. If you choose a HELOC vs. a cash-out refinance, make sure you carefully monitor your spending and interest accumulation.

Reverse Mortgage

If you’re over the age of 62 and would like to boost your retirement savings, you may want to consider a reverse mortgage. There’s no monthly mortgage payment with a reverse mortgage, though you must still pay taxes and insurance.

With a reverse mortgage, your loan amount is based on the amount of equity you have in your home. If you have an existing mortgage, the proceeds of the loan are used to pay that off. The rest is available for you to use as you see fit.

You can get the proceeds from your reverse mortgage in several ways

As a lump sum of cash at closing

Through monthly payments that you’ll get as long as you live in your home

Through monthly payments for a fixed period of time

Through a line of credit that you can draw on at any time

A reverse mortgage can be a good choice for homeowners who plan to stay in their home indefinitely and aren’t worried about leaving an inheritance. It can give you cash in retirement if you don’t have anywhere else to get it. 

Summary

Your savings and retirement accounts aren’t necessarily your only assets. Your home itself is one of your biggest assets.You can use your home’s equity for a variety of reasons, including making home improvements and consolidating debt. There are several financial options that can help you use your home equity.For homeowners who want to a low-interest way to borrow against their home, cash-out refinancing is often a good choice.