- Home equity is how much of your home you own based on how much you’ve paid off.
- You can borrow against your home equity.
- But borrowing against your home equity isn’t always the right move.
A cute little house with a white picket fence is a lot more romantic than the portion of the American Dream it represents: home equity.
Building home equity increases your net worth. But it also gives you something potentially more valuable. The more of your home you own, the more tangible assets you have to borrow against when you need it.
Fortunately, home equity really is as simple as it sounds. There are just a few things you need to understand about how it works, especially if you plan to borrow against it.
What Is Home Equity?
Home equity is how much of your home you own based on how much you’ve paid off. To calculate it, subtract how much you still owe on the home from the property’s total value.
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So if you’ve paid off your mortgage and don’t owe any other money on it, your home equity is whatever your home is worth. If your home is worth $400,000, and you owe $100,000 on your mortgage, you have $300,000 in home equity.
You can’t spend home equity, but it’s still real money. It counts toward your net worth and you can even borrow against it.
How Home Equity Works
When most people buy a house, they take out a loan called a mortgage so they can pay for it. The entity lending the money, the bank, has an ownership interest in the property until you pay it off. But they don’t own it outright.
However much money you’ve put into the house is a portion of the house you own too. That portion is your home equity. “Equity” is a share, and as you pay off your home, you have more and more shares.
Your first equity in your home is your down payment. Then, each month, whatever portion of your mortgage goes to principal (not interest) is even more equity. And you gain even more equity if the home’s value increases. But you can also lose equity if your home value drops below what you paid for it.
For example, let’s say you buy a tiny home for $15,000. You put down $3,000 and finance the rest on the elusive (because it’s not real but makes a fantastic example) one-year mortgage.
That means you start with $3,000 equity in your tiny home. You pay off the remaining $12,000 in 12 equal installments of $1,000 plus interest, increasing your equity by $1,000 per month until you have full equity in the home, which will be $15,000 if nothing changes. But if your home gains value (appreciates), which it’s likely to do, you could have more.
When you have enough equity, you can use it as a type of currency by borrowing against it in the form of a home equity loan or line of credit. And if your equity is greater than the original purchase price, you’ve made money on the investment.
How to Calculate Your Home Equity
The value of your home equity can be a bit of a moving target. If you still owe money, it changes every time you make a payment. Even if you don’t, it changes with the value of your home, which can increase or decrease based on things you can’t control (market factors) and things you can (home improvements).
To calculate your home equity, you need to know two things: the current value of your home and how much money you owe on it. The whole thing’s relatively straightforward, but there are some things you should know.
The current value is the fair market value, or what someone would realistically pay if they bought the home. When you first purchase your home, what you paid for it is usually the current value. However, the value may depart from that number over time. Hopefully, it will increase, meaning your home will be worth more than you paid for it.
The only way to be sure is with an official appraisal. And if you’re borrowing against your home’s equity, your bank may require it. It’s also possible they’ll rely on a statistical model called automated valuation, which compares your home to other homes in the neighborhood.
You only need to shell out the several hundred dollars a human appraiser costs if you need a 100% accurate appraisal or wish to dispute the bank’s appraisal. Otherwise, an automated valuation works just fine.
You can get one of those by checking house-hunting sites like Zillow or Trulia. It may not be the same number your bank would have, but it can get close enough to let you do some worthwhile back-of-the-napkin math, at the very least.
If you still have a mortgage, you can find out how much you owe by checking your latest bill or contacting your mortgage company. The number you want is the principal, or the amount you owe minus any interest or fees.
The principal is the money you originally borrowed, minus what you’ve already paid on the loan. The rest is interest, which is the bank’s profit for lending you the money. It doesn’t count toward your equity.
Your statement may also have a total payoff amount. Don’t use that amount, either. It may include penalties for early payoff, which also don’t count toward your equity.
Even if you don’t owe money, there’s one more thing to consider. Do you owe any outstanding payments to contractors who did work on your home? You can ignore any recent work. This would be work you had done some time ago and never paid the contractor for.
If so, they can put a lien on your home in the amount of the outstanding balance. A lien is their way of saying that if you ever sell the house, they get their money before anyone else. That way, if you’re broke, they’ve staked a claim.
This type of debt counts against your home equity because you quite literally owe it to someone else. If you’re just doing some math, it counts as part of the amount owed. In reality, it could block a loan. That means you need to clear the debt before you can borrow against your house.
If you have any other debts secured by your home, count those, too.
Home Equity Formula
After you have the information on your home’s current value and how much you owe, the formula is pretty simple:
Current Value – Amount Owed = Home Equity
For example, let’s say Zillow estimates your home is worth $250,000. You check in with your lender, and the current amount owed, not including any interest or fees, is $15,000.
$250,000 – $15,000 = $235,000
That means you have $235,000 in home equity.
If you need to know the percentage of home equity, which may come up for certain loan types, just do that calculation, then this one:
Home Equity ÷ Current Value = P, then move decimal to the right twice for percentage of home equity
So for the same house, you have 94% home equity.
$235,000 ÷ $250,000 = 0.94 (or 94% after moving the decimal)
Uses of Home Equity
The primary benefit of home equity is its value as something you can borrow against. There are several ways to use your home equity.
- Home Equity Loan. A home equity loan allows you to borrow a loan using your home as collateral. As you pay it off, you get your equity back.
- Second Mortgage. A second mortgage is a home equity loan you take out while you’re still technically paying off the first mortgage. It works the same as a home equity loan on a home you own free and clear, but could be smaller because you still owe money on the property.
- Home Equity Line of Credit. A line of credit is revolving credit, like a credit card. You can borrow against it as needed, pay it back, then borrow against it again. In the case of a home equity line of credit, or HELOC, your home secures the loan.
- Mortgage Refinance. If you still owe money on your mortgage, you can refinance it. That’s helpful if you now qualify for lower interest rates than you did when you first borrowed or want to do things like lower your monthly payment or change the loan term.
- Cash-Out Refinance. If you refinance your home but want additional cash on top of the loan amount, a cash-out refinance is the way to go.
- Reverse Mortgage. With a reverse mortgage, the lender pays you, with your home used as collateral. You can pay it back or not. If not, your estate has to pay it back in full when you die or the home goes to the lender — not to whoever you left it to in your will.
- Take Out a Blanket Loan. Would-be rental property owners can use their current home as collateral for a rental property. This option is best for experienced owners with several rental properties and a financial advisor or lawyer smart enough to talk you out of it if it’s a bad idea for you.
This should go without saying, but just because you can do something doesn’t mean you should. Borrowing against your house puts your home at risk if you don’t pay it back.
Pros & Cons of Using Home Equity
But that doesn’t mean there aren’t specific pros and cons to lookout for.
|Lower interest rates||Fees and closing costs|
|Predictable fixed payments||House may cost more overall|
|Choose your loan term||Payments may become unmanageable|
|Larger loan availability||Risk of going underwater|
|Flexibility||Risk of foreclosure|
|Interest may be tax deductible||May still need to qualify|
Pros of Using Home Equity
Depending on how you use your equity, there are several potential benefits, especially over another form of loan.
- Lower Interest Rates. Loans based on collateral like your home typically have lower interest rates than other loan types.
- Predictable Fixed Payments. Using your home equity usually results in predictable fixed payments, so you always know what to expect. The exception is if you purposely refinance into an adjustable-rate mortgage or take out a variable-rate or interest-only HELOC.
- Choose Your Loan Term. If you want to pay off your mortgage faster, choose a shorter term and higher payments. If you want lower payments, choose a longer term. You’re master of your own destiny, at least insofar as your creditworthiness allows. Note that you should only lower your payments if you truly need it to afford them. For example, if you’re very close to paying off your home when you have to take a lower-paying job, it might be worth keeping your equity. Otherwise, you might consider downsizing your home instead.
- Larger Loan Availability. Once you’ve built significant equity, you can borrow a lot more money against it than you probably otherwise could have qualified for.
- Flexibility. You can use home equity to borrow for virtually anything you like. When you take out a traditional bank loan, they have to approve of what you plan to use it for. In this case, it’s already your money and your house is collateral, so they care less what the money’s ultimate destination is.
- Interest May Be Deductible. Depending on the type of loan you take out, some or all of your interest may be deductible on your income taxes.
Cons of Home Equity
As with the advantages of using your home equity, its disadvantages depend on how you use it and the terms of the loan. Be mindful of these potential downsides.
- Fees and Closing Costs. Using your home equity essentially means taking out another loan. And loans often come with fees. You may even have to pay closing costs all over again.
- The House May Cost More Overall. If you’re careful, you can save money by using your equity to refinance, lowering your interest rate and paying off your mortgage faster. But if you’re not careful, you can increase the total amount of interest you pay on the house, increasing the overall cost of buying it.
- Payments May Become Unmanageable. Using your equity sometimes means increasing the amount of time you owe money. If other obligations rear their ugly heads, a big mortgage payment could become a burden. Plus, if you take out an interest-only HELOC, the principal balance will eventually come due if you haven’t been paying it down, possibly extending the amount of time you owe money on your home.
- Risk of Going Underwater. If you borrow too much and your home’s value declines, you could end up owing more on your home than it’s worth. That would put you underwater on your mortgage — not the most desirable financial position to be in, especially if something goes wrong and you lose the house.
- Risk of Foreclosure. Any time you owe money backed by your home, you’re at risk of losing the home to foreclosure if you don’t repay the loan.
- May Still Need to Qualify. Banks would rather own houses than lose money, but they don’t really need houses, either. So they’re going to check your credit and ensure you qualify for the loan just the same. If your credit has deteriorated since you bought the house, you might not qualify.
Should You Use Home Equity?
You can sleep in your car, but you can’t drive your house. That doesn’t make losing your house a desirable outcome. Only use your home equity if you need to or it will benefit you in some way.
Using your home equity is advantageous if doing so doesn’t put you in danger of losing your home and:
- It decreases your interest rate.
- It lowers your monthly payments enough to make them manageable without losing existing equity.
- It shortens your loan term.
- It nets you a better rate than another type of loan.
- You’re using the funds to consolidate high-interest debt (like credit cards), which could save you money in the long run.
- You’re using the funds for a home improvement project, which makes the interest deductible.
That’s not to say you can’t use your home equity for other reasons. But carefully consider whether they’re worth risking cons like foreclosure if things go sideways.
Home Equity FAQs
Home equity is one of those really simple subjects that can get really complicated based on your personal circumstances. If you still have questions about home equity after this article, ask your financial advisor before jumping into any loan backed by it.
Are There Alternatives to Home Equity?
Yes and no. You may not own anything else of sufficient value to borrow large amounts against. For those who do, it’s very possibly a 401(k) account.
Borrowing against your 401(k) ensures you don’t risk losing your home. But losing your retirement fund isn’t much better. And it comes with some pretty steep tax penalties. If you have a low risk tolerance or are in serious financial trouble, it may be better to do without or save up than borrow against either.
For small amounts, there’s no time like the present to start an emergency fund. That’s a separate bank account with at least three to six months of enough cash to live on if you lost your job. If you get your fund up to a year’s worth, you can easily borrow up to six months of it if you need to.
You can also take out a credit card or personal loan with a no-interest introductory rate and pay it back before the introductory period is over.
Do I Need a Mortgage to Tap Home Equity?
No. Once you pay off your mortgage, assuming you don’t owe anyone else, you have 100% home equity to borrow against. You don’t need an active mortgage to do so.
Does It Cost Money to Use Home Equity?
Yes. You might be able to find a loan or line of credit without any additional fees, but you always pay interest one way or another.
Are There Any Qualifications for Using Home Equity?
Yes, again. You usually need a bare minimum of 10% home equity to borrow against, and more likely 15%. Plus, you have to meet all the same requirements you would if you were borrowing any other type of loan. So say hello to another credit check.
If you’re lucky, you’ll be able to sit on your home equity the entire time you live in your home and just let it be part of your net worth. Fortunately, if you need it, borrowing against your home equity is often cheaper than traditional loans.
But that doesn’t mean you should take the first offer you get. Shop around for the best home equity loan and HELOC rates available, and don’t hesitate to refinance with a different lender if they can get you a better deal. You don’t owe your current lender anything that’s not outlined in your contract.