Wondering what home equity is? We explain what it is and how it can help you build wealth.
If you’re in the market for a house and you’re wondering, what exactly is home equity, you’ve come to the right place. We’ll break down exactly what home equity is and how homeowners benefit from it.
What is home equity?
In short, home equity is the percentage of your home that you own.
If you just bought a house and made a 3% down payment, you own 3% of the home. If you’re halfway through a 30-year mortgage, you have 50% equity. Once you pay off your house, you have 100% equity in the home.
For example, if you owed $150,000 on a home valued at $300,000, you would have $150,000 in home equity.
Home equity is a form of wealth, and it’s an asset you can leverage to further grow your wealth. In fact, it’s one of the biggest benefits of owning a home.
How do you build home equity?
Most homeowners build equity in two ways:
- By making payments on their mortgage: Making your home loan’s regular payments lowers your mortgage balance, growing your home equity month by month. Making extra payments on your loan’s principal helps you increase your equity faster.
- Through property appreciation: As your home grows in value, your home equity grows, too. Historically, real estate appreciates as time passes, although it is possible for a home to lose value, too.
Ideally, you’ll build home equity in both these ways, simultaneously.
Let’s say you bought a $300,000 home two years ago. You’ve paid the loan balance down to $280,000. By making payments, you’ve already built $20,000 in equity.
Meanwhile, property values on your street have grown by 10%, meaning your $300,000 home has grown in value by $30,000. That $30,000 in equity, combined with the $20,000 in equity you built by making payments, would total $50,000 in home equity.
Some housing markets have seen such double-digit percentage increases in home values over the past couple of years. This has built a lot of real estate wealth in the form of home equity.
Why is building home equity important?
Building equity is one of the biggest benefits of buying your own home. Having home equity is a lot like having money in saving bonds or in a retirement fund. It’s a financial asset.
Each time you make a mortgage payment, a part of your payment becomes an investment in real estate — specifically, in your own home. You won’t get this benefit by paying rent; instead, your house payments build equity for your landlord.
Once you’ve built up some home equity, you can use it in a variety of ways.
Ways to use home equity
Homeowners can’t spend home equity like it’s cash, but they can leverage part of their equity to borrow money. Because they’re secured by your home’s value, home equity loans can offer lower interest rates than you might receive on credit card or personal loans.
Let’s say you have built up $100,000 in home equity on a home valued at $300,000. You could use part of your equity to secure three different types of loans:
- Home equity loan: Also known as a “second mortgage,” a home equity loan works a lot like your primary mortgage loan. You’ll get a fixed interest rate and fixed loan payments. But instead of using the cash to buy your house, as you did with your primary mortgage, you can use the money any way you’d like.
- Home equity line of credit (HELOC): A HELOC is another type of second mortgage. But instead of borrowing a lump sum of cash, you can borrow from your equity as needed. It’s kind of like a credit card but with a much lower variable interest rate.
- Cash-out refinance: A cash-out refinance pays off your current mortgage and allows you to borrow cash against your equity. The new loan includes however much you still owed on your previous mortgage plus the amount you borrowed in cash. Unlike the first two options, a cash-out refi leaves you with only one mortgage payment instead of two.
You can use money from a home equity loan, HELOC or cash-out refinance however you choose. Some people use the money to consolidate high-interest debt, renovate their homes, make a down payment on an investment property, or pay for their children’s college tuitions.
Bear in mind, however, that you are borrowing against your home and you are taking on more debt by using your equity. It’s prudent to use the money strategically toward long-term financial or quality-of-life goals rather than non-essential expenses. You may want to consult your accountant about the best ways to leverage your equity.*
What is home equity? FAQs
What is house equity and how does it work?
Home equity represents how much of your home you own, or how much of your mortgage loan you’ve paid off. If your home is worth $300,000 and your mortgage balance is $200,000, you have $100,000 in home equity.
Do you have equity if your home is paid off?
Yes. In fact, you have 100% home equity when you’ve paid off your home. If you sold the home, you could keep all of the profits instead of using the money to pay off a mortgage loan.
What happens when you take equity out of your house?
When you borrow against your home equity, you increase the amount of debt you owe on the home. You can take cash out of the home via a cash-out refinance, home equity loan or home equity line of credit (HELOC). However, you will likely be extending the repayment timeline on your home, and you may pay more for the home over time than if you had simply paid on the original mortgage. There are strategic reasons to borrow against your home’s equity, but it’s a good idea to talk with your accountant about the wisest way to use your equity.
The bottom line on home equity
Home equity provides homeowners with financial flexibility. As your equity increases, you have options for how you’ll leverage the home, and you can use the equity to achieve other financial goals. Building home equity is an important step toward building and establishing generational wealth.
*This article does not constitute tax advice. Please consult a tax advisor regarding your specific situation.
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