What Is Home Equity?

Home equity is the part of your home’s value that belongs to you and not your mortgage lender.

• Home equity equals the value of your property minus the total of all loans against it.

• You earn home equity when you pay down your mortgage balance(s) and when your property value increases.

• You can cash out your home equity by borrowing against it or selling your home.

Home equity is an essential asset for most consumers. In fact, the net worth of homeowners averages 40 times that of renters.

How to Calculate Home Equity

You can express home equity in two ways -- as a dollar amount and as a percentage. To determine your home equity, you need your home value and mortgage balance. You can estimate your property value with online tools from real estate sites or get a more accurate number from a real estate broker or home appraiser.

Suppose that your home is worth $300,000 and has a $225,000 mortgage balance. To determine the dollar amount of your home equity, simply subtract your total mortgage balances from your estimated home value. 

$300,000 - $225,000 = $75,000

In this case, you have $75,000 in home equity. But there’s another way to look at your home equity -- as a percentage of your property value. To calculate your home equity percentage, you take the amount of home equity and divide it by the current value of your home. 

$75,000 / $300,000 = .25

You can see that you have 25% equity in your home. And your mortgage equals 75% of your home value. Mortgage lenders call that your loan-to-value ratio, or LTV. 

How Much Home Equity Can You Borrow Against?

Everyone wants to know, “How much equity can I borrow from my home?” Most lenders will not allow you to borrow against all of your equity. Lending against 100% of a homeowner’s property value is too risky for most lenders. 

In most cases, lenders allow you to borrow against 80% of your property value. That’s an 80% LTV.  Some might go as high as 90% for applicants with excellent credit and income. 

Calculate How Much You Can Borrow With a Home Equity Loan

It’s not difficult to determine how much you can borrow. Simply multiply your estimated property value by .8 for an 80% LTV or by .9 for a 90% LTV. Then subtract your current mortgage balance. 

If your property value is $400,000 and your mortgage balance equals $300,000, your maximum home equity borrowing at an 80% LTV looks like this:

• $400,000 * .8 = $320,000

• $320,000 - $300,000 = $20,000

Understand that if your actual property value is less than your estimate, your maximum loan amount also drops. 

Home Equity Loan Pros and Cons

Home equity financing has advantages and drawbacks. Here are home equity pros.

• Low interest rates -- there is minimal risk to lenders because home equity loans are secured by a valuable asset. Less risk means better interest rates.

• Extended repayment terms -- repayment terms for typical home equity loans range from ten to 30 years. That helps keep payments low.

• Flexibility -- there are several ways to borrow against your home equity -- fixed-rate second mortgage (HELOAN), home equity line of credit (HELOC), cash-out refinance, and reverse mortgage. 

• You can tap into your home’s value without the hassle and expense of selling and moving.

Home equity financing also has a few drawbacks. 

• Risk – if you find yourself unable to make your home equity loan payments, you risk foreclosure and the loss of your property.

• The setup cost can be higher than that of other types of financing and can include home appraisal fees, title, and escrow charges.

• Borrowing against home equity can deprive you of an essential asset for retirement. The US Census Bureau says that home equity makes up nearly one-third of household wealth.

The key to using home equity wisely is borrowing for the right reasons and only borrowing what you can afford to repay. 

Best Uses for Home Equity

How can you use home equity? In most cases, you can take cash out of your home for any legal purpose. However, home equity is valuable and should not be tapped lightly. In many cases, it’s cheaper to borrow smaller amounts with another product like personal loans or even credit cards because the setup costs are lower, even if the interest rates are higher. 

In addition, personal finance experts don’t generally recommend financing short-term things like cars or vacations with long-term loans. It’s tempting because a long-term loan means a lower payment. But do you really want to spend the next ten years paying for a two-week vacation? 

Here are some good uses for home equity. 

• Real estate purchase – for experienced investors, using home equity to purchase rental property can be a wise move.

• Home improvement – improvements that add value can increase your home equity while improving your quality of life. Choose wisely, however. Some “improvements” can actually decrease your property value. 

• High-interest debt consolidation – If you owe a substantial amount of debt carrying high interest rates, consolidating it with a home equity loan can drastically reduce your interest rate and payment. However, you should not undertake debt consolidation if you don’t control your spending first, or you’ll be worse off than before. 

• Emergency fund – HELOCs can be great for providing access to emergency funding for your business or personal needs. Set one up before you need it because if you end up in financial trouble, you’ll have difficulty getting a loan.

• Other investments, like starting a business or paying for college, can be good uses for home equity – as long as you are qualified to succeed in your field, choose a business or degree that will provide a good return, and work hard. 

Understand that you can significantly reduce your home equity interest cost by paying your loan off as quickly as you can.

Types of Home Equity Loans

There are several options for taking equity out of your home. Each has pluses and minuses and is best for specific uses and borrowers. 

Home Equity Loan (HELOAN)

The least complicated home equity loan is often called a “second mortgage.” Here are the characteristics of the typical HELOAN:

• Interest rates and payments are generally fixed.

• You receive a lump sum and repay it with equal installments over the loan’s term.

• You’ll likely encounter closing costs like appraisal fees and title charges.

Home equity loans are ideal when you need a large sum all at once. They can make budgeting easier because your payment and interest rate don’t usually change. Good uses for HELOANs include buying another property, paying a builder for a renovation, debt consolidation, or financing a medical procedure. 

Home Equity Line of Credit (HELOC)

What is a HELOC? The home equity line of credit, or HELOC, is a little more complicated than the HELOAN. Here are the characteristics of most HELOCs. 

• HELOCs are credit lines, which means you can use them and repay them over and over during the draw period – much like you do with credit cards.

• The draw period typically ranges from five to 10 years, depending on the length of the HELOC term. 

• You only pay interest on your HELOC balance, not the entire credit line.

• Your minimum monthly payment is just enough to cover the monthly interest charge during the draw period.

• Once the draw period ends, you enter the repayment period. During the repayment period, you make monthly payments over the remaining term of the loan. These payments can change over time if your interest rate is variable. 

• Some HELOCs allow you to fix your interest rate once you enter the repayment period. Or even at one or more times during the draw period. These are called “convertible” HELOCs.

HELOCs can be riskier than HELOANs because of their variable interest rates. And because your payments at the end of the draw period can increase sharply if you’ve used much or all of your available credit. 

However, HELOCs have advantages too. You can use them like credit cards, but their interest rates are lower. When you have an ongoing expense, like home improvements that take place in stages over time or college tuition paid every semester, the HELOC’s flexibility can be beneficial. Because you only pay interest when using the credit line, HELOCs also make sense as emergency funds for your business or personal life.

Cash-Out Refinance

The cash-out mortgage refinance is exactly what it sounds like. When you choose a cash-out refinance, you replace your existing mortgage with a larger loan, and you get the difference between the old loan payoff and the new loan balance in cash. 

If, for instance, your home is worth $200,000 and you owe $100,000 against it, you might choose to take out $50,000 in cash. Assuming that the loan fees, title, and escrow charges come to $5,000, your new loan amount would be $155,000. 

Cash-out refinancing delivers a lump sum, and your interest rate is usually fixed. In that, it’s similar to fixed-rate HELOANs. But the new interest rate is generally lower than that of a HELOAN, and it applies to the entire loan balance, not just the cash you take. 

Cash-out refinancing can be helpful when you can improve on the interest rate of your existing mortgage, and you need a large sum of cash. The fees for a cash-out refinance are higher than those of a “regular” rate-and-term mortgage refinance, and they apply to the entire loan amount, not just the cash-out. Even though the interest rate is lower than that of a HELOAN, the cash-out refinance can cost much more in setup charges. Wherever you consider a cash-out refinance, compare the cost to a rate-and-term refinance combined with a HELOAN before committing.

Reverse Mortgage 

The reverse mortgage is a complicated product with a particular purpose. You usually have to be at least 62 years old to be eligible for a reverse mortgage, and your mortgage must be paid off or have only a small balance. Here are the characteristics of most reverse mortgages.

• You take cash out with a reverse mortgage. You can choose to receive a lump sum, take a line of credit, get a series of monthly payments for a set term, or receive monthly payments for as long as you live in the home. You can even choose a combination – for instance, a small lump sum with a line of credit.

• The amount you can borrow with a reverse mortgage depends on your age, mortgage balance (if any), and property value. 

• You have to repay the reverse mortgage only when you move, sell the home, or die. Typically, the sale of the property pays off the loan, and any remaining proceeds go to you or your heirs. If the sale does not bring enough to cover the loan balance, the lender writes off the remaining balance. Neither you nor your heirs are responsible for paying it. 

Reverse mortgages can be great options for those who are house-rich but cash-poor and who don’t qualify for traditional home equity loans or cash-out refinancing. The advantage is that your income and credit rating don’t count much because you don’t make mortgage payments. To avoid foreclosure, you only have to pay your real estate taxes, insurance, and home maintenance.

Home Equity Loans: A Big Decision

Home equity is the cheapest kind of financing for most purposes because the lender can take your home if you fail to repay your loan. It is important to remember that anything that makes a loan safer for lenders makes it riskier for borrowers. Think carefully before committing to any home equity product and consider all options before tapping that valuable asset.