You’ve probably heard the phrase “home equity,” likely during a commercial asking you to pull the equity out of your home through a home equity loan or home equity line of credit (HELOC). So, what is home equity?
In short, home equity is the market value of your property (what it's worth today) less any liens/mortgage balances. For example, if your home is worth $500,000 (as determined by comparable properties in your area and your home upgrades), but your mortgage balance is $450,000, the home equity, or actual ownership in your home, is $50,000. Please keep in mind that the equity amount is determined once value is established by a certified appraisal. This will vary by state.
Now, let’s take a look at how you can build and use your home equity.
Home Equity Builds as Mortgage Payments are Made
As you make mortgage payments each month, your home equity will steadily increase. In the beginning, most of your mortgage payments will go toward interest, but as your mortgage balance decreases over time, more of your monthly payment will go toward principal. Any additional funds given when you make payments will also go directly toward your principal, which really builds your home equity.
Home Equity Increases as Home Prices Increase
If home prices do rise, you will grab a larger amount of home equity.
Using our previous example, if the value of the home increases to $550,000, your home equity would rise to $100,000 (i.e., $50,000 in home value increase + $50,000 in existing home equity). It would actually be more than $100,000 thanks to mortgage payments made between the time the home’s value increased from $500,000 to $550,000, but you get the idea.
This is where homeownership starts looking attractive. That combination of regular payments reducing the principal balance and home prices increasing can prove pretty beneficial to you.
Just keep in mind the opposite is also true, and if you refinance and pull “cash out” at market peak, you may find yourself underwater on your mortgage(s). That is, you may end up owing more on your home than its market value. So, it’s important to know your exact mortgage balance versus the market value of your home before considering refinancing, a home equity loan, or a HELOC.
Choosing the Home Equity Option That’s Right for You
If you have equity in your home and you need cash for expenses, you have the options of refinancing, getting a Home Equity Loan, or a HELOC.
In a nutshell, most borrowers choose to refinance their mortgage either to take advantage of lower interest rates or to cash in on equity accrued in the home. When you refinance your mortgage, you are essentially trading in your old loan for a fresh one with a new interest rate and term—and, possibly, even a new balance. The bank or mortgage lender that grants you the new mortgage essentially pays off your old mortgage with a new mortgage, thus the term refinancing.
With a home equity loan, you borrow from the equity you have in your home. You receive a lump sum and make monthly mortgage payments on the total amount borrowed, usually at a fixed rate.
A HELOC is simply a line of credit that allows a homeowner to borrow up to a pre-determined amount set by the mortgage lender. It not only gives you the freedom to decide when and if to use the money, but also how much you need to pay back and when. This pre-determined amount will also vary by state.
How Can Home Equity be Used?
You can use your home equity for anything you’d like—even things not associated with your home. However, it is usually used for some of life’s larger expenses because homes tend to have a lot of value to borrow against. For example, you will find that a number of borrowers want to:
Remodel, renovate, or otherwise improve the house and property (click here to learn about our renovation loan options)
Pay for a family member’s college education
Fund the purchase of a second home
Consolidate and/or pay off high-interest debts
You can borrow money using the value of your home as a guarantee, and you can use that money for any purpose. You can also borrow money specifically for the purpose of renovating or repairing your home without any guarantee. Any loan that is backed by the value of your home is called a home equity loan, whereas a home renovation loan is a secured or unsecured loan for fixing up your home.
Using Your Home Equity Sensibly
Before using a Home Equity Loan for any purpose, you should be aware of the risks of using these loans. The main concern, like with any mortgage obligation, is that you can lose your home if you fail to meet the payment schedule required by the lender.
Since these loans can provide an abundance of available funds, it's tempting to use your loan for unnecessary expenses. Best practice is to use your home's equity only for the most important expenses—things that will improve the value of your home or improve your income are good examples.
So, when used appropriately, you home’s equity can be a great option for the larger expenses in your life. If you'd like to explore your Home Equity Loan options, click here to contact one of our mortgage specialists or visit our Mortgage Resource Center for more information.