Home equity—the current value of your home minus your mortgage balance—matters because it helps you build wealth. When you have equity in your home, it’s a resource you can borrow against to improve your property or pay down other high-interest debts. However, it’s also volatile because home values are always changing, sometimes dramatically. To get a home equity loan, you’ll need a stable income and good credit.
Home equity is a large component of many people’s household wealth. That’s especially true for Black and Hispanic households, who “have seen outsized gains in housing wealth over the past decade,” according to the Federal Reserve.
At the end of 2019, about 28% of Hispanic families’ wealth and 20% of Black families’ wealth came from home equity, compared to about 16% for white families. The percentages are so high in part because the housing market has been strong over the last decade, and in part because Black and Hispanic families—which have less wealth overall than white and Asian families—have a higher percentage of their wealth tied up in home equity.
What Is Home Equity?
Home equity is the difference between your home’s current market value and your mortgage balance; it can be positive or negative. When it’s positive, it’s an asset you can draw on, typically up to 80% of your home’s value, which can be key when you have few other assets (stock holdings and cash emergency funds, for example). It’s also a cushion against a market downturn that could otherwise prevent you from selling your home.
When you have negative equity, selling your home isn’t enough to pay off your mortgage. That’s how a lot of homeowners were forced into short sales or foreclosures during the Great Recession.
How Home Equity Works
Your home equity depends on two aspects: your mortgage principal and the local housing market. In a perfect world, as you repay your mortgage, your equity would increase. That’s because your home value minus your mortgage balance equals your equity. However, that’s not the case if the value of your home is decreasing.
Factors beyond your control impact how desirable homes are in your area and influence your property value, which play a role in determining if your equity decreases, stabilizes or increases over time.
In many markets, housing shortages have pushed home prices (values) up in recent years: think San Francisco, Los Angeles, Denver and Seattle. Nationwide, the housing supply—the number of homes available for sale—is at a historic low, according to the National Association Realtors.
But if you live in a city with a declining population and aging housing, your home’s value may be on the decline. Even as you pay down your mortgage, your home equity may be shrinking.
While the state of the housing market is out of your hands, there is one thing you can do to try and preserve the value of your home: maintenance. A home that is clean, comfortable and well cared for will always be more desirable than one that isn’t (except to some real estate investors that prefer neglected properties).
How You Build Home Equity
You can build home equity in two ways:
- Home price appreciation. The market value of your home—the amount you could sell it for—goes up.
- Mortgage principal reduction. As you pay down your mortgage principal, your equity increases, as long as your home’s value is stable or increasing.
The longer you’ve had your mortgage, the faster you build equity with each monthly payment. If you review a mortgage amortization schedule, you’ll see that most of your payment goes toward interest at the beginning of your loan term. With each payment, you owe less money and accumulate less interest. More of your next payment then goes toward your principal.
Calculating Home Equity
Follow these four steps to calculate your home equity:
- Find your home’s estimated market value using an online tool or by looking at recent sale prices of comparable properties.
- Check your last mortgage statement to see how much principal you owe.
- Subtract your mortgage balance from your home value with this formula:
Home value – Mortgage balance = Home equity amount
- If you want to know your home equity percentage, not just your home equity amount, use this formula:
(Home value – Mortgage balance) / Home value = Home equity percentage
Here are some examples to help you understand the math.
How to Use Your Home Equity
Home equity is a valuable resource. If you borrow against it, you can technically use the money however you want. However, it’s common to use it for larger expenses like home renovations, higher education, debt consolidation or relocating.
HELOCs
A home equity line of credit (HELOC) gives you access to as much as 80% to 85% of your home’s value. Instead of receiving a lump sum amount of money, you can use a line of credit on an as-needed basis. You will only need to pay interest on the amount you borrow and interest rates are variable.
Home Equity Loan
Unlike a line of credit, a home equity loan lets you receive up to 85% of your home’s value as a lump sum payment. You’ll pay interest on the full amount and be expected to repay the loan in five to 30 years depending on your specific loan terms. If you know how much you need to borrow and you want the security of a fixed interest rate, a home equity loan is a good choice.
Cash-out Refinance
A cash-out refinance can be a good way to access your home equity when you want to refinance your existing mortgage to get a lower interest rate or access additional financing for other expenses. It allows you to borrow up to 80% of your home’s value and replaces your current mortgage with a new, larger mortgage. The money you receive is the difference between your old and new mortgage.
Reverse Mortgage
Homeowners who are at least 62 years old and have a low or no mortgage balance can use a reverse mortgage. These mortgages let you borrow against your considerable equity and get a loan you may not ever repay yourself. Instead, when you move or die, your heirs will list and sell the property to repay the reverse mortgage amount.
Down Payment on a New House
Some people buy a less expensive home to start out, then sell to upgrade when their finances are stronger. The equity you accumulate through years of homeownership can become the down payment for your next home when you sell.
Sell and Return to Renting
After experiencing homeownership, some people decide it’s not worth it. The time and money involved in maintaining a home can be significant. Selling allows you to cash out all of your equity and use it however you want.
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Advantages of Using Home Equity
- Securing a loan with your home allows you to get a low interest rate.
- Interest rates are low compared to other forms of borrowing.
- You can use the money for almost any purpose.
- Interest may be tax-deductible if you use itemize deductions.
- You can typically borrow up to 85% of your home’s value, depending on your total equity.
Drawbacks of Using Home Equity
- You can lose your home if you default on a home equity loan.
- You’ll pay loan fees and interest to tap into your equity.
- It sets you back on the path to debt-free homeownership.
- Your savings from itemizing home equity loan interest may be minimal.
- You may not be able to tap into your equity when you need it most because loan qualification depends on market conditions, your income and your credit.
