As you make your monthly mortgage payments, you own a larger and larger percentage of your home. But to take advantage of this equity, you’ll have to know how much equity you have, and you also need to know how to get access to that cash.
By tapping into your home’s equity, you can get the money you need to pay off high-interest debt. You can pay for a major remodel or invest in your kids’ college education. So what is home equity? Here’s a quick guide on how to calculate it and how you can put it to use.
What Is Home Equity?
Home equity is the share of your home’s value that you actually own. Let’s say your home is worth $300,000, and you owe $100,000 on your mortgage. In that situation, you’d have $200,000 in home equity – $300,000, minus the $100,000 you owe the bank.
There are two ways to earn equity in your home. The first is to make your regular monthly mortgage payments. Part of those payments goes to interest, but the rest pays down your loan balance. The second is to invest in home improvements that increase the home’s value.
That said, you aren’t in total control of your home’s value. National or local market forces could cause it to go down. You’ll lose equity if the value drops faster than you’re paying off your loan balance.
[ Rental property investor, rehabber or wholesaler? Get to know which investing strategy is the best fit for YOU by attending our FREE online real estate class. ]
How Does Home Equity Work?
Home equity can sound complicated at first, but it’s really not. Let’s use a quick example to show how it works.
Let’s say you purchase a house for $250,000. You make a 10% down payment, which comes out to $25,000. Your lender then provides the balance of the purchase price in the form of a $225,000 mortgage loan.
Assuming $250,000 is the home’s fair market value, you already have $25,000 in equity. That’s $250,000, minus the $225,000 loan. If you overpaid, you might actually have less equity. If you underpaid, you might have more.
Fast forward five years. If you’ve made all your payments on time, you might only owe $200,000. At the same time, home values in the area may have risen, so your home is now worth $265,000. At this point, you’d have $65,000 in equity – $265,000 minus $200,000.
Keep in mind that this can work the other way. Let’s say you’ve made all your payments, but the market has taken a nosedive. You’d still owe $200,000, but your home’s value might have dropped to $240,000. In that case, you’d have $40,000 in equity – $240,000 minus $200,000.
As you can see, it’s not enough to know how much you paid for your house and how much you owe. You also need to know what your home is currently worth. You’ll have to hire a licensed real estate appraiser to get an official value that a lender would accept.
That said, you can get a rough idea of your home’s value by looking at other homes in your area. Hop on Zillow or another website, and look up similarly-sized homes in your zip code. Find several numbers, and calculate the average. This won’t get you a precise value for your home. But it will get you a ballpark figure for what you should expect.
How To Calculate Your Home Equity
To calculate your home equity, you need to know two things: how much your home is worth and how much you still owe on your mortgage principal.
We’ve already talked about how to find out your home’s value. To find out how much you owe on your mortgage principal. In most cases, this number will be on your mortgage statement. If you can’t find it, call your lender and ask them.
Once you know both of those numbers, making the calculation is simple. You subtract the principal on the loan from the value of the home.
Suppose you owe $75,000 on your mortgage, and your home is worth $200,000. Subtract $75,000 from $200,000, and you get $125,000. That’s how much equity you have in your home.
If you want to refinance your home, take out a home equity loan, or open a line of credit, your lender will require an appraisal. You’ll need to hire an appraiser to come out and determine the fair market value. You can get close by doing your own estimate, but the appraiser will have the final say.
How To Build Home Equity
Let’s say you want to build equity as quickly as possible. How would you go about it? Here are some ways to do it.
Make A Large Down Payment
This method is a no-brainer. If you want to have more equity right off the bat, put down a larger down payment. Not only will you have more equity, but a smaller loan means lower mortgage payments and less interest over the life of the loan.
Suppose you’re buying a $250,000 home. If you put down 5%, or $12,500, you’ll only have $12,500 in equity and a $237,500 loan. If you put down $25,000, you’ll have twice the equity and only owe $225,000. But why stop there? You’ll be much better off if you can afford to put down $30,000 or $40,000.
Before you even make an offer on a home, you’ll need to know how much of a down payment you can afford. This is part of getting a mortgage preapproval, which is a big part of the home buying process. By offering a larger down payment, you’ll often be able to get preapproved at a lower interest rate.
Pay Off Your Mortgage
Every time you make a mortgage payment, a part of that payment will be used to pay down the principal balance. However, a lot of your money goes towards interest, with additional charges for property taxes and homeowners insurance.
When you first purchase your home, a larger amount of money will go towards interest payments, and a smaller amount will go towards the principal. As the principal is paid down, you’ll accrue less and less interest, and a larger portion of each payment will go towards the principal.
So for the first few years, you won’t be gaining much equity. Towards the end of your loan term, you’ll be gaining equity much more quickly.
That said, not all loans work this way. With an interest-only mortgage, your monthly payments are just enough to cover the interest. You don’t actually accrue any equity. At some point, you’ll have to make a lump sum payment to pay off the loan. In the mean time, your only equity in the home is whatever you paid for the down payment.
Pay More Than Your Required Payment
Imagine you have a monthly mortgage payment of $1,000, and it’s early in your loan. Less than $300 per month would be going towards your principal. But there’s a catch.
If you make an extra payment, the full amount will go towards your principal. $100 more per month might not sound like much on a $1,000 payment. But you’re not adding it to the $1,000. You’re adding it to the less than $300 you’re paying towards your principal.
Stay In Your Home For 5+ Years
Property values tend to go up over time, but short-term decreases are common. If you plan on moving very soon, one of these downturns could put you underwater on your mortgage, meaning you have zero equity because you owe more than the house is worth.
But in most cases, your home will be worth more than it was five years ago. The longer you stay, the more you can take advantage of this natural increase in value.
Renovate Your Home
Adding improvements like extra rooms or energy-efficient windows can increase your home’s value. Even landscaping investments can grow your home’s equity.
How To Use Home Equity
So far, we’ve talked about what home equity is and how you can get more of it. But what is it good for? People often use their home equity to pay for significant expenses like remodels. And since home equity loans have lower interest rates than credit cards, people often use them to pay down credit card debt.
However, you can also use your home’s equity to invest in your future.
Buy A New Home
If you’ve already lived in your home for several years, your life circumstances have probably changed. Maybe you’ve had a new addition to your family. Maybe you got a promotion and you’re moving out of state. Or maybe you just want a bigger house. Regardless of your reasons, you want to move.
Using your equity, you might be able to afford a bigger house. Let’s say your current house is worth $250,000. You still owe $185,000, so you have $65,000 in equity. If you sell the house for market value, you’ll be able to put that $65,000 towards a new house. You could buy a $300,000 house and still only have to borrow $235,000.
Your monthly payments in this case would be about the same as they were on your old house. Meanwhile, you’d have a larger house. If you were to move into a similarly-priced home, the large down payment would result in a lower initial balance, so your monthly payments would be lower.
Using Equity For Your Retirement
If you’re aged 62 or older, you can take out a reverse mortgage. This is a special type of loan where you stop making payments on your mortgage. Instead, you’ll receive payments based on how much equity you’ve built in your home. If you own your home outright, you’ll have access to almost the full amount.
You can choose to take your payment as a lump sum, open a line of credit, or receive monthly payments. You can also combine any of the three payment methods. How much money you can borrow depends not just on your equity, but also on your age and current interest rates.
Your loan never comes due, unless you move out for longer than six months, sell your home, or pass away. Similar to a regular mortgage, you can sell the property, you’ll have to use the proceeds from the sale to repay the loan.
When you pass away, you can still leave your home to your heirs. They can choose to refinance the house with a regular mortgage and keep it. Or, they can sell it, and use the proceeds to pay off the loan. Under no circumstances can they be required to pay back more than they can sell the house for. In other words, your heirs won’t be held personally responsible for any of the debt.
How To Borrow Against Your Home’s Equity
To turn your home’s equity into cash, you’ll have to borrow against it. There are three ways to do this: a cash-out refinance, a home equity loan, and a home equity line of credit.
Any borrowing might feel somewhat unsettling if you’re financially responsible. But if you have to borrow money, home equity loans and lines of credit aren’t a bad way to do it. You’ll pay far less interest than you’d pay for a comparable personal loan or a credit card.
That said, tapping your home’s equity is also dangerous. If you go into default, the lender could default on your home. Defaulting on your credit card debt will ruin your credit, but it won’t get you kicked out of your house. Before you borrow, make sure you’re equipped to repay the loan.
With a cash-out refinance, you refinance your mortgage for more than what you owe. After you pay off your first mortgage, any excess money you’ve borrowed goes right into your bank account. The more equity you have in your home, the more you’ll be able to refinance for.
For example, imagine you owe $150,000 on your house, which is worth $250,000. You could refinance for $200,000, and pocket the $50,000. This $50,000 money could then be used for whatever you like.
Keep in mind that you’ll still have to repay the new mortgage. So while you’d have $50,000 in cash, you’d repay $200,000, making regular monthly payments just as you did with your original mortgage.
Home Equity Loan
A cash-out refinance replaces your original mortgage with a newer, bigger mortgage. With a home equity loan, you’re taking a second mortgage in addition to your primary mortgage.
Imagine the same scenario above, where you owe $150,000 on a $250,000 home. Rather than refinancing, you could take a home equity loan for $50,000.
With a home equity loan, the lender pays your money in a single lump sum. You then pay the debt off over time, just as you would with a mortgage. This is why many people call it a second mortgage.
Home Equity Line Of Credit
A home equity line of credit, also known as a HELOC, is a line of credit tied to your house. Let’s go back to our scenario with the $250,000 home and $150,000 mortgage debt. What happens if you open a $50,000 line of credit?
Your bank would give you a withdrawal period, typically around five years, where you can freely draw on that line of credit. You can borrow as much or as little as you want, as long as it doesn’t exceed your credit line, and you can make as many individual withdrawals after that.
Following your withdrawal period, you’ll repay whatever you borrowed during a payment period, typically 5, 10, or 15 years. The nice thing about a HELOC is its flexibility. If you open a $50,000 line of credit and only end up needing to borrow $35,000, you’ll only have to repay the $35,000.
What is home equity? It is one of the most powerful financial tools at your disposal. By tapping into this resource, you can make investments in the future. You can even purchase a larger home at a favorable interest rate. Not only that, but accessing your equity is easy. With a cash-out refinance, home equity loan, or HELOC, you’ll get your cash in just a few weeks.
Ready to start taking advantage of the current opportunities in the real estate market?
Whether you’re brand new to investing or have closed a few deals, our new online real estate class will cover everything you need to know to help you get started with real estate investing. Expert investor Than Merrill explains the best real estate strategies to help get you on the path towards a better financial future.
Register for our FREE 1-Day Real Estate Webinar and get started learning how to invest in today’s real estate market!