What is home equity?

© Loop Images/Getty Images  Home equity: what is it and how to use it.

By Jeanne Lee, Bankrate

Home equity is the portion of your home that you've paid off - your stake in the property, as opposed to the lender's. In dollars, it is the estimated market value of your home minus the balance remaining to be paid on your mortgage. For many homeowners, home equity is their most valuable asset.

What is home equity?

In practical terms, home equity is the appraised value of your home minus any outstanding mortgage and loan balances. In most cases, home equity builds over time as you pay down mortgage balances or add value to your home. Home equity is an important asset for homeowners, since it can be used to borrow home equity loans or lines of credit.

How does home equity work?

Whether you’re looking to free up cash for a home renovation or find ways to consolidate debt, borrowing against the value of your home could be a good option. While you pay off your home, you build equity that you can later use for loans or home equity lines of credit (HELOCs).

Because you can use equity for loans or tap into it when selling your home, it’s a great financial tool. And the bigger your down payment and the more you pay toward your mortgage, the greater chance you have at increasing your total equity.

If you’re considering using your home equity, keep the following steps in mind:
  • Build your equity. You can increase the equity in your home by making payments on your mortgage or making home improvements that increase your property’s value.
  • Calculate your equity. Subtract your mortgage balance from your home’s value.
  • Consider the benefits and drawbacks of a home equity loan. Using home equity to fund emergency expenses or consolidate debt isn’t the right choice for everyone. Before applying for a home equity loan, consider the risks of using your home as collateral and look into personal loan options.
  • Learn if you qualify. Lenders typically require 20 percent equity, a minimum credit score in the mid-600s and a debt-to-income ratio below 43 percent before you can borrow from your home equity.

What is a home equity loan example?

Most lenders require you to have a certain amount of equity in your home before you’re eligible for a loan. Let’s say your home’s current market value is $300,000 and you have $180,000 remaining on your mortgage. To find your home equity, subtract $180,000 from $300,000: $120,000.

Because $120,000 is 40 percent of $300,000 ($120,000 / $300,000 = 0.40), you have 40 percent equity and a 60 percent loan-to-value ratio (the percentage of your home that you're still paying off).

Lenders typically cap borrowers’ loan-to-value ratio at 80 or 85 percent, meaning you won’t qualify for a loan if your LTV ratio is higher than that. If you have a low LTV ratio, meaning you have more equity in your home, you may qualify for better rates.

Once you qualify, your lender will also determine what percentage of your equity you can borrow. This is also typically around 80 percent. In this scenario, you would multiply your home’s value ($300,000) by 0.80 (the maximum percent the lender allows you to borrow) and subtract your remaining mortgage ($180,000). Here’s what that looks like:

$300,000 x 0.80 – $180,000 = $60,000

That $60,000 is how much you’ll be able to take out in a home equity loan.

View home equity rates

Tap into the value you have in your home to get the funds you need.

Types of home equity loans

There are two types of home equity products, which differ in how you receive the cash and how you repay funds:
  • Home equity loan: A second mortgage, paid in a lump sum and repaid in monthly installments.
  • Home equity line of credit (HELOC): Similar to a credit card, a line of credit with a limit for what you can borrow and a variable interest rate.

Home equity loans

A home equity loan is a second mortgage, meaning a debt that is secured by your property. When you get a home equity loan, your lender will pay out a single lump sum. Once you've received your loan, you start repaying it right away at a fixed interest rate. That means you'll pay a set amount every month for the term of the loan, whether it's five years or 15 years. This option is ideal if you have a large, immediate expense. It also comes with the stability of predictable second-mortgage payments.

Home equity lines of credit (HELOCs)

A home equity line of credit, or HELOC, works like a credit card. You can withdraw as much as you want up to the credit limit during an initial "draw" period that is usually up to 10 years. As you pay down the HELOC principal, the credit revolves and you can use it again. This gives you flexibility to get money as you need it.

You can opt for interest-only payments or a combination of interest and principal payments. The latter helps you pay off the loan more quickly.

Most HELOCs come with variable rates, meaning your monthly payment can go up or down over the loan's lifetime. Some lenders offer fixed-rate HELOCs, but these tend to have higher initial interest rates.

After the draw period, the remaining interest and the principal balance are due. Repayment periods tend to be from 10 to 20 years. A HELOC that is used for a substantial home improvement project may be tax deductible.

Home equity loans vs. HELOCs

Home equity loan Home equity line of credit (HELOC)
Type of interest Fixed rate Variable rate
Repayment term 5 - 10 years 10 - 20 years
Payout Lump sum Revolving credit
Type of loan Secured Secured
Best for Debt consolidation, major renovation costs Minor renovation costs over a number of years

How do you build home equity?

Because home equity is the difference between your home's current market value and your mortgage balance, your home equity can increase in a few circumstances:
  • When you make mortgage payments.
  • When the property value rises.
  • When you make certain improvements to the property.

How do you calculate home equity?

To calculate the equity in your home, follow these steps:
  1. Get your home's estimated current market value. What you paid for your home a few years ago or even last year may not be its value today. You can use online real estate tools, but consider talking to a local real estate agent. A lender will order a professional property appraisal to determine your home's market value.
  2. Subtract your mortgage balance. Once you know the market value of your home, subtract the amount you still owe on your mortgage and any other debts secured by your home. The result is your home equity.

Are home equity loans a good idea?

Home equity loans may make sense for people who want to take advantage of low interest rates and long repayment terms. However, before you commit to using your home equity, make sure to consider the benefits and drawbacks.

Benefits of using home equity

Home equity can be a useful tool when you need a large sum for home improvement, debt consolidation or any other purpose. Home equity loans and HELOCs have their benefits, like:
  • Lower interest rates. Your home is what makes your home equity loan or line of credit secure. These loans have lower interest rates than unsecured debt, such as credit cards or personal loans. This can help you save on interest payments and improve monthly cash flow if you need to lower high-interest debt.
  • Tax benefits. The 2017 Tax Cuts and Jobs Act allows homeowners to deduct the mortgage interest on home equity loans or lines of credit if the money is used for capital improvements, such as to "buy, build or substantially improve" the home that secures the loan.

Drawbacks of using home equity

Using home equity doesn't work for everyone in every situation. Drawbacks include:
  • Borrowing costs. Some lenders charge fees for home equity loans or HELOCs. As you shop lenders, pay attention to the annual percentage rate (APR), which includes the interest rate plus other loan fees. If you roll these fees into your loan, you'll likely pay a higher interest rate.
  • Risk of losing your home. Home equity debt is secured by your home, so if you fail to make payments, your lender can foreclose on your home. If housing values plummet, you could wind up underwater, meaning you owe more on your home than it's worth. Your credit and finances could take a major hit, too.
  • Misusing the money. You should only use home equity to finance expenses that will pay you back, like renovating a home to increase its value, paying for college, starting a business or consolidating high-interest debt. Stick to needs versus wants; otherwise, you're perpetuating a cycle of living beyond your means.

How to qualify for a home equity loan

To qualify for a home equity loan, here are some minimum requirements:
  • Your credit score is 620 or higher. A score of 700 and above will most likely qualify for the best rates.
  • You have a maximum loan-to-value ratio, or LTV, of 80 percent - or 20 percent equity in your home.
  • Your debt-to-income ratio is no higher than 43 percent.
  • You have a documented ability to repay your loan.
Lenders have varying borrowing standards and rates for home equity products, so you'll want to shop around for the best deal.

It also helps to know how much you want to borrow and what you're using the money for. Home equity loans are long-term loans that take years to repay, so borrow only as much as you need and make sure you’re prepared for as many as 30 years of payments.

Next steps

Home equity is a great financial tool that you can use to help pay for big expenses like a home renovation, high-interest debt consolidation or college expenses. If you need a large amount of cash, you may want to consider borrowing some of the equity you have built up in your home. But you should do so with care and shop around with multiple lenders before signing up.

FAQ for home equity

Can you use a home equity loan for anything?

Unlike with personal loans, there aren’t many limits on home equity loan uses. You can use your loan for consolidating debt, paying for medical expenses or financing a vacation. However, not all of these are the best uses for a home equity loan. Typically, it’s best to use your home equity loan for things that will add value to your home, such as home renovations, since this will give you even more equity.

Is home equity an asset?

Home equity is considered one of the most valuable assets a homeowner can have. This is because home equity can increase over time, and homeowners may use it to access funds in the form of a loan.

Does a home equity loan require an appraisal?

While not every home equity lender requires a full appraisal, all lenders need to determine the value of your home in order to calculate your available equity. If your lender doesn’t require a full appraisal, it may obtain these estimates by looking at county assessments, using automated value models or even driving by your home and taking photos. If you’ve had a full appraisal done within the last six months, the lender may also be able to use that information.

See more at Bankrate

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