A Guide to Home Equity

Learn About Home Equity and How It Affects Your Finances

What is home equity? That’s a great question, because understanding home equity is important to homeowners. Home equity is the part of your home's value that belongs to you, not your lender. You can access your home equity to accomplish financial goals, or you can cash in your equity when you sell your home.

This guide explains what home equity is, how it works, how to build equity in your home, and how home equity can benefit you.

What is Home Equity?

Home equity is the value of your house minus the amount you owe on your mortgage or any liens against your home. You own the equity in your home, and it is one of your assets, while the rest of the value of your home is owed to the lender until your loan is paid off.

When you first buy a house, your home equity is usually equal to your down payment. If you buy a house for $250,000 with a down payment of $25,000, you typically begin with $25,000 in home equity -- unless you get a great deal and paid less for the home than its market value, in which case you benefit from a little extra equity immediately.

After you buy a house, the value of your home equity can change as your home's value changes. Hopefully, it should increase over time. The U.S. Treasury estimates that average home values in the country have increased 65% (when adjusted for inflation) over the past 25 years.

How Does Home Equity Work?

It's important to understand how home equity works.

As a homeowner, you definitely want to build equity in your home. That's because the more equity you have in a house, the greater the value of your investment in your home.

Fortunately, there are many ways to build equity, including taking steps to reduce your loan balance or to increase your home value.

How to Build Equity in Your Home

Increasing your equity increases your net worth. If you have more equity in your home, you will make more profit when you sell your home or have the ability to borrow money secured by your home at a lower rate when compared to personal loans.

You can build home equity in a few key ways, including:

• Make a large down payment: As mentioned, when you buy a home, your down payment gives you instant equity in the home. The larger your down payment, the more of your home value you own debt-free and the less the lender has a legal interest in.
• Make mortgage payments: As your loan balance declines, the lender has less legal interest in your home and you gain that home value as an asset of your financial portfolio.
• Home appreciation: You build equity when your home value goes up due to changes in market conditions. If your house is worth more than you paid for it, that appreciation gives you more equity.
• Make home improvements: Improvements typically increase the value of your home. When you increase your home's value, you increase the amount of equity available from your home.

How to Calculate Home Equity

As a homeowner, you should know more than just the home equity definition. You should also know how to calculate your home equity. Fortunately, this is easy. Here's how you can figure out how much home equity you have.

1. Determine your home’s current market value: To calculate your home's equity, start by finding an estimate of the current market value of your house. Your home’s equity can be calculated through an appraisal, a comparative market analysis from a real estate agent, or through online tools (which may be less accurate than the first two options). While a home appraisal will provide a more accurate estimate, it’s important to note you will have to pay an appraisal fee for this service.
2. Find your current mortgage balance: You can find out how much you owe by looking at monthly statements from your home loan lender. You can also call your lender and ask, or find this information on your credit report.
3. Subtract your loan balance from your home's value: Take the current market value of your house and subtract your current mortgage balance.
4. Subtract other loans or liens that use your home as collateral: If you have a second mortgage, HELOC, or other loans guaranteed by a lien on your house, you'll need to subtract that amount from the market value.

This will show you how much equity you have. The table below provides an example of how to calculate equity in a home.

Some portion of this home equity is usually considered to be accessible equity, which means you can access that equity to do other things.

What is Accessible Equity?

"Accessible equity" is a phrase real estate professionals use to describe the amount of money you might be able to access (or borrow) from your home’s equity.

Most of the time, you can’t borrow the full amount of your equity. Instead, you can only "tap" or access a portion of its value because most loan options require that you keep 20% equity in your home (the exception is VA loans).

One way to calculate accessible equity is by determining the total amount you can borrow based on the lender's allowable loan to value ratio. The image below shows you how accessible equity can vary based on your current remaining mortgage balance. The more of your mortgage you have paid off, the more equity you can access.

Here's an example of an accessible equity calculation:

Ways to Use Your Home Equity

To understand how home equity works, you also need to know how to use your home equity.

If you are a homeowner, you can access home equity by selling your home. You'll walk away with the equity when you sell, after the remaining mortgage and selling costs and fees are paid.

However, there are also other ways you can benefit from your equity without selling, including by accessing the money through a home equity loan, a home equity line of credit, or a cash-out refinance.

Below are a few ways that you might benefit financially from your home equity.

Remove PMI and Save Money

If you are paying for private mortgage insurance (PMI), it’s important to keep an eye on your current home equity.

Many conventional mortgages require you to pay for PMI if you have less than 20% equity in your home. Once you reach this amount, you can request that your lender remove PMI from your mortgage. This reduces your monthly payment and saves you money immediately.

Your lender is required to remove PMI once your loan balance drops to 78% of your home's value. However, you can and should request that it be removed once you are at 80% loan-to-value ratio so you can remove that expense from your monthly payment.

Pay for Large Expenses

Your growing home equity can also be an available low-cost cash source for big expenses. For example, you can borrow against the value of your equity to finance home improvements, pay for college or vocational training, or cover the costs of medical treatments.

If you take the equity out of your home to do these things, be aware that you are increasing the debt on your home. If you can’t afford to make monthly payments, your lender could be forced to foreclose on the property. You typically don't want to tap equity to cover a big expense unless it is for an important purchase and you are confident you can pay back the money.

Consolidate Debt

When you access your home equity, these loans (especially a cash-out refinance – more on that below) generally have a much lower interest rate than the rate on other unsecured debts, such as credit cards.

This means that if you access your home equity to pay off higher-interest debt, like credit cards, you can save money paying it down with a lower interest rate.

You can also pay off multiple debts and have one monthly payment to make instead of many. Having just one payment simplifies the repayment process and can help reduce the chance you will miss one of the payments. Assuming your equity loan has lower interest than the debts you’re consolidating, you’ll benefit from more affordable monthly payments. This is not without its risks, so you’ll want to speak to a financial professional to decide whether this is the best option for you.

Refinance your Mortgage

Finally, your home’s equity can help you refinance your mortgage to a lower rate. That’s because the value of your equity affects your loan-to-value ratio (LTV). Having a significant amount of home equity lowers your LTV ratio. Lenders can typically offer customers with lower loan-to-value ratios competitive interest rates when refinancing.

You can do a rate and term refinance, which keeps your loan balance the same but simply allows you to save money with a lower interest rate or repay your loan faster with a shorter term.

You can also do a cash-out refinance, which replaces your current mortgage with a new, larger loan and gives you a portion of your home equity in cash at closing. The amount of home equity you have affects the amount of money you might be able to borrow. Cash-out refinancing allows you to borrow against your equity at a new interest rate.

Is Using Home Equity a Good Idea?

Now you can answer the question, "How does taking equity out of your home work?"

However, you need to know if using your equity makes financial sense. There are advantages and disadvantages of borrowing against your home equity. Here are a few that you should consider.

Final Thoughts: Home Equity

Ultimately, there are many factors affecting both whether you can access your home equity and whether you should.

Think carefully about this and talk with a mortgage professional to understand more about "what is equity in a home?", how to calculate the equity of your home, and whether borrowing against your equity could improve your finances. Contact Freedom Mortgage today to find out how much money you could save by taking advantage of your hard-earned home equity.