What is Home Equity?
Points of Interest
Home equity, which is the amount of your home mortgage loan that you’ve paid down, gives homeowners access to powerful borrowing tools that you can utilize when, and if, needed.
If you’re a homeowner or are interested in buying a house, you may be familiar with the term “home equity.” Building equity is one of the main reasons many renters decide to purchase a home — and for good reason.
While the term has a limited role in the purchase of a home, home equity becomes important when you sell your home or need to borrow money. It’s important to understand what home equity is and how you can use it, especially if you own or plan to buy a home.
What is home equity?
In simple terms, home equity is the amount of your home loan that you have paid down. Unless you’re an all-cash buyer, you’ll take out a mortgage loan when you purchase your house. Technically, you don’t fully own your home until that loan is paid off. The value of your house, minus the balance you owe on your mortgage, is your equity. In other words, if you were to sell your house, the remaining cash left over after you pay off your mortgage loan is your equity.
For example, let’s say that you purchased a $300,000 home and put down a 10% down payment of $30,000. You took out a loan for the remaining $270,000. Over the course of the next year, you paid off another $10,000 of your principal amount — or the non-interest part of your loan. Remember, part of your payments go toward paying down the principal and part goes toward your interest.
At this point, you owe $260,000 on your loan because you have paid off $10,000 in principal already. If you value the home at the same $300,000, you would have $40,000 in equity in your home. The value of the home ($300,000) minus the remaining loan balance ($260,000) equals $40,000 in equity. If the value of your home goes up, your equity also goes up. If the value of the home goes down, your equity will also go down.
How to use home equity
As a homeowner, you’ll have access to borrowing tools that are specifically for people who own homes. Under normal circumstances, you would have sell your home to cash in on your home’s equity, but these home equity-focused financial tools allow you to tap into your home’s equity without having to put your house on the market. Some of the most popular uses of these products are debt consolidation, home improvement projects or other major life purchases.
Types of home equity products
The two most popular home equity products are home equity lines of credit (HELOCs) and home equity loans. Each of these tools gives homeowners the ability to borrow against their home equity for a number of reasons.
- Home equity line of credit (HELOC) — A home equity line of credit is a revolving line of credit made available to homeowners who have equity built up in their homes. Instead of being given a lump sum of cash, you are given access to a revolving line of credit that works much like a credit card, only HELOCs are secured by your home and its equity as collateral.
A HELOC typically has a draw period where you are able to use and reuse the funds, followed by a repayment period where you make fixed payments to pay off the loan. For example, if you are looking to do some remodeling and are not sure how much money you need, you can take out a HELOC if you have enough equity in your home. You’ll be given a line of credit (the maximum you can use) and a draw period to use those funds (usually 5-10 years). During the draw period, you can use funds as you need and pay them back to restore the line of credit, just as you would with a credit card, while only paying interest on the money you borrow. When the draw period ends, you’ll need to make payments on the money you actually used.
To get a HELOC, contact a lender that offers the product. This does not need to be the same lender that your original mortgage is through. You can help to expedite the process by having all of your current loan, housing, and income information and asset documents ready to go.
- Home equity loan — A home equity loan operates like a traditional fixed-rate loan. You’ll be given a lump sum upon approval of your loan. The amount that you’re approved for will be based on the equity you currently have in your home. Be aware that a home equity loan uses your home as collateral, so a default risks foreclosure.
Popular uses for home equity loans are larger-scale remodeling projects, debt consolidation or major purchases. To apply for a home equity loan, you’ll need to reach out to a lender that offers the product. Make sure you have all the documentation for your home and loan on hand. You’ll also need to have the income and asset documents needed for most loans.
Alternatives to home equity
Home equity loans and HELOCs aren’t the only option you have if you need access to cash. Depending on your specific financial needs and your current financial situation, one of the other options may be a better fit. These include:
- Personal loan — Personal loans are available for homeowners and non-homeowners with various limits and interest rates. These loans are unsecured, so you don’t risk losing your home if you default, but you very well may pay a higher interest rate and/or have to have a high credit score to qualify. A personal loan most closely resembles a home equity loan.
- Credit cards — Another viable option is credit cards. These borrowing tools are similar to HELOCs in that the funds are revolving. Unlike a HELOC, though, payments are due immediately, rather than several years later.
- Cash-out refinance — A third option you can consider is a cash-out refinance. Unlike personal loans and credit cards, this option is only available to homeowners. You can refinance your loan for a higher amount and withdraw the difference as cash. You will need to have a decent amount of equity in your home, though.
Home equity is a great barometer of your successes in paying off your mortgage. The more money that you put toward your home, the more equity you’ll have in your home. Having equity in your home can help you get access to more types of borrowing and let you see a nice return of the money you’ve paid when you sell your house.