November 2, 2022
What is home equity?
Home equity is the current appraised value of your home minus what you owe, which includes all outstanding mortgage and loan balances. For example, if your home is worth $300,000 and you owe $200,000, then you have $100,000 in equity. At the most basic level, any gain in home equity comes from paying down on the loan’s principal balance or through an increase in market value. There are multiple ways to potentially increase the home’s market value, which will be discussed in greater detail below.
How do you find out how much you have?
An appraisal is the most accurate way to find out the value and, subsequently, how much equity you have in your home. Additionally, some mortgage companies will provide an estimate based on real estate trends and how much you owe when you view your loan information on the website or app. You can also use a home equity calculator to receive an estimate.
How does it work and what can you do with it?
Generally, home equity is money you have accrued from paying down the principal on your mortgage, but there are ways to tap into it aside from selling your home. A home equity line of credit (HELOC) allows you to borrow against your home equity during a period of time – say five or ten years, which is known as a draw period. During this time, you can continue borrowing as you repay the principal. Once the period ends, you will enter the repayment period, in which you can no longer borrow and must pay off the remaining principal and interest. HELOCs are typically offered with variable interest rates, and you only have to pay interest on the money you use, not the entire amount you are able to access. They differ from home equity loans in that they offer a revolving line of credit, as opposed to a fixed amount of money for a fixed amount of time.
Home equity can be especially useful for home improvement projects. Typically, you can receive a lower interest rate when using your home as collateral in a secured loan like a HELOC, as compared to an unsecured loan such as a credit card or personal loan. It is important to spend the money on projects that will increase the value of the home, though, not on unnecessary luxuries that add little real value.
Why is it important?
For many, home equity is a long-term strategy for building wealth. As home values rise and you pay down the principal on your mortgage, you can accumulate wealth. Homes are unlike most other assets in that they typically increase in value over time, which is why they are one of the most valuable assets you can own.
How can you increase the equity in your home?
There are several steps you can take to potentially build home equity, beginning with the down payment and running throughout the life of the mortgage.
- Make the biggest down payment you can reasonably afford – if you are able to make at least a 20 percent down payment, you will eliminate the private mortgage insurance (PMI) premium
- Make bigger and/or additional mortgage payments – adding extra money to the principal every month, or at least from time to time, will help you build home equity faster and pay your mortgage off sooner, which will also save you money on interest
- Refinance and/or shorten your mortgage term – if your mortgage rate is higher than the current rates being offered, it may be worthwhile to refinance to a lower rate to save money on interest over the remaining years. You can also shorten the term of the loan by refinancing and pay the home off sooner
- Rework your budget – it may be worthwhile to revisit your budget to see where you can cut costs to contribute more toward the principal each month
- Invest in remodeling and home improvement projects – increase the value of your home by remodeling or taking on a home improvement project that will boost the appeal of your property
- Wait for the value of your home to increase – sometimes patience brings the biggest returns in home equity. But remember, if the value of your home is increasing, it is likely that other homes in the area are also increasing in value, so you will want to factor that in when deciding on the best time to sell and relocate.
When you should refrain from using home equity
Home equity is a great resource for homeowners, but it should be used with caution. Three DON’TS related to home equity include:
- DON’T use home equity to purchase unnecessary luxuries – purchasing items such as cars, vacations, TVs, etc. will not add any value to the home
- DON’T tap home equity if you plan to sell soon – you need to pay off all debts related to your home before you can sell it, so you should not use your home equity for projects or expenses if you are unable to pay off the loan or line of credit before closing
- DON’T take out excessive equity – you do not want to find yourself in a situation in which the real estate market drops and you are left with negative equity in the home
Home equity can be one of the greatest benefits of owning a home if you make the most of it. Traditionally, it is wise to follow the ‘five-year rule,’ which states that it typically takes at least five years to build enough equity in a home to recoup the initial purchase costs if you choose to sell and buy another home. This period can take even longer if the market cools down by the time you are looking to sell. When this happens, it is best to wait so you can maximize your return.