What Is Home Equity?

How Does Home Equity Work?

If you provide a down payment when you get a loan to buy a home, that amount represents your initial equity in the home. As you make monthly mortgage payments and, ideally, your home’s value increases, your equity grows.

Home equity is an important asset for many people, as it allows homeowners to borrow money if necessary or potentially make their money back and then some when they sell the property.

The larger the down payment you provide when buying a house, the more equity you start off with. In addition to owning more of your home from the outset, providing a bigger down payment allows you to take out a smaller mortgage and reduce how much interest you’ll pay over the life of your loan. Lenders also often reward a larger down payment with a lower mortgage interest rate.

Borrowers who put down less than 20% on conventional loans are often required to pay for private mortgage insurance (PMI). This protects the lender should the borrower be unable to repay the loan. Typically, PMI can be canceled once 20% equity is achieved, but the ongoing expense up until that point can add up. As a result, some buyers may choose to save for a larger down payment so they can avoid paying PMI and start off with more equity in their home.

How to Calculate Your Home Equity

You can calculate your home equity by subtracting what you owe on the mortgage from the home’s current market value. The difference indicates your equity, or ownership stake.

For example, say your home is currently worth $300,000, and you owe $240,000 on your mortgage. Simple subtraction shows that you have $60,000 in home equity.

To find a percent, divide the amount you’ve paid off by the current home value, then multiply it by 100. For this example, you would divide 60,000 by 300,000, then multiply by 100 to get 20. That shows you have 20% equity in your home. The percentage may be important if you take out a home equity loan or home equity line of credit (HELOC) since lenders will typically only lend up to a certain percentage of your equity.

How to Build Home Equity

If you want to grow your home’s equity faster, there are a few ways to make it happen:

• Make a bigger down payment. You can aim to put down as large a down payment as possible so you begin homeownership with a higher equity stake—and less debt to repay. Even putting down 10% rather than 5% can give you a helpful head start on building equity.
• Pay down your loan faster. Whenever you can afford it, pay more than you owe on your mortgage, or make biweekly payments instead of monthly. The faster you pay down your loan, the quicker you’ll accumulate equity. Just make sure you’re aware of any prepayment penalties or lender restrictions on loan payments.
• Wait for your home to appreciate. If your home is in a growing or popular area, home prices are likely to rise over time. This helps you build equity passively without doing anything other than making your monthly mortgage payment.
• Invest in your property. Certain home improvements can boost your home’s value, which increases your equity and could allow you to sell the house for more. Upgrades such as new floors, an updated kitchen or a new pool can boost value but are also expensive, so make sure you’re likely to get a solid cost-to-value return. There are several online tools you can use to calculate cost versus value, which compares the average cost of specific remodeling projects with the value those projects are likely to retain at resale.

How to Use Home Equity

Your home equity is a useful asset you can eventually put toward the purchase of a future home—but you can also tap that equity before you ever sell your home. Several types of financial tools allow you to borrow against your home equity, using your home as collateral. They can help you pay for home improvements, debt consolidation or other major life expenses. Borrowing against your home does come with risk, however, since you can lose your home if you fail to repay your loan. These forms of financing can also come with significant fees.

The three most common financial tools that utilize home equity include:

• Home equity loan: Often called a second mortgage, a home equity loan provides a lump sum which you then repay in fixed installments over a set term (often anywhere from five to 30 years). Most lenders allow you to borrow up to 75% or 85% of the home’s equity. Because these loans are secured by your home, interest rates are often low, especially compared with credit cards or unsecured personal loans.
• Home equity line of credit (HELOC): Rather than providing you a lump sum to repay over time, a HELOC offers a revolving line of credit you can borrow from again and again as you pay down the balance. HELOCs have a draw period, usually 10 years, during which you can borrow up to a certain amount and only pay interest on what you’ve borrowed. When the draw period ends, you can no longer borrow and have to pay the HELOC back in full (usually over 10 to 20 years). HELOCs offer more flexibility if you expect to have ongoing expenses rather than one large purchase.
• Cash-out refinance: Using a cash-out refinance entails refinancing your mortgage for more than you owe and pocketing the difference. While it can help you utilize your home equity in a pinch, it does require taking out an entire new mortgage to replace your new one—which means more closing costs and possibly a longer repayment period.

Consider Other Borrowing Options

Deciding whether to borrow against your home’s equity can be a tough decision. Interest rates are competitive, but you can lose at least some of the equity you’ve built and put your home at risk, on top of paying potentially hefty fees.

Another option to consider is an unsecured personal loan, which may have slightly higher interest rates but typically fewer fees, and will keep your home equity intact. With Experian CreditMatch, you can get free personalized offers for personal loans.