Our Super Simple Guide to Home Equity

Every homeowner should keep track of their home equity. This knowledge can empower you to use your home equity if you need it.

The keyword here is need. We'll guide you with a list of pros and cons below to help you decide if you should use your home equity.

What Is Home Equity?

Home equity is calculated based on your home's current market value minus your mortgage balance.

Let's say your home is worth $200,000, and you still owe $150,000 on the mortgage. Your home equity is $50,000. If a buyer came to you today and offered you $200,000, and then you turned around and paid off your mortgage, you'd have $50,000 to put in your bank account.

Building equity in your home is helpful for a few reasons:

Increasing your overall net worth
Using the proceeds of the sale of your home to fund your next home
Borrowing against to upgrade or redecorate your home

Below we'll take a deeper look into how you can figure out your home's equity, how to increase it, and what you might want to do with it.

How Does Home Equity Work?

For most people, home equity is simply a number that they see increasing (hopefully) or decreasing (hopefully not) monthly or yearly.

The Rise

Assuming your home's value is rising, and you're paying down your mortgage, you're building equity in your home. It's money that you can tap into if you want to, but many people are happy to let their equity grow until they own the house free and clear.

For those who don't like the idea of their money being locked in, homeowners can use home equity to open a HELOC (home equity line of credit) which usually comes with a lower interest rate than a personal loan.

The Fall

On the flip side, a home can have negative equity when its value decreases and the buyer wants to sell it but still owe more on the mortgage than the sale will bring.

A Historical Lesson in the Fall of Home Equity

Think back to the Great Recession of 2008-2009 and how housing prices dropped dramatically. If a $200,000 home dropped in value to $150,000, but the homeowners still owed a $170,000 loan balance, that leaves them with a $20,000 deficit. To sell their home, they'd need to come up with the extra $20k to pay off the mortgage.

Job losses and other financial factors made this impossible for many people, so mortgage holders had no choice but to let the bank repossess their homes and try to sell them to recoup their investment.

For people who could ride out the downturn in home prices, this wasn't a huge deal. Sure they couldn't borrow against their home, but they also hadn't lost any real money. For those who couldn't, a period of financial instability - and even homelessness - beckoned.

In the decade since then, we've seen home prices rise year on year. But, if you look back at historical home prices, you'll see a cyclical pattern in most markets: Prices go up, drop down, go up to their previous high and maybe even surpass it before dipping down again.

How to Calculate Your Home's Equity

To figure out how much equity you've built in your home, follow these three simple steps:

Step 1

To find the approximate value of your home, go to Zillow.com and type in your address. You will see that it shows your Zestimate, which is what their algorithm believes your home is worth. Write this number down on a piece of paper. You can also check out other real estate listing websites to compare and use an average of what all of the sites believe your home is worth.

Step 2

Next, find your most recent mortgage statement and write down the balance. For accuracy, subtract the mortgage payment you made this month.

Step 3

Subtract your mortgage balance amount (step 2) from your home's value (step 1). Easy-peasy, right? That's the amount of home equity that you have.

How to Build Equity in Your Home

The most obvious way to build equity in your home is to pay down the mortgage. Every monthly payment applied towards the principal is another dollar added to your equity balance.

In the early years of your mortgage, most of your monthly payment will be going towards interest, so your equity will build slowly.

To accelerate this, and as long as your lender does not have a prepayment penalty, you can make additional payments on your mortgage and specify that you want the extra payment to go towards the principal.

The size of your down payment also affects the amount of equity you have. The more money you put into your house upfront, the more you have going forward. Over time your home will, hopefully, appreciate, and this adds to the amount of equity you have in it.

Making improvements on your property may also help you create more equity. Adding a deck, updating the HVAC system, or repairing a badly worn roof will help increase the value of your home.

Using the $200,000 purchase price example, let's say you've paid down your mortgage to $150,000, but your home is now worth $300,000. In this scenario, you now have $150,000 in equity. Conversely, if the value drops below $150,000, you have negative equity.

If your neighborhood is seeing a significant change in demographics or crime rates start to rise, your home values may drop, causing a decrease in your equity.

Before buying your home, research the trends and scout out neighborhoods well so that you can avoid ending up in an area that's experiencing a decline in property values.

How Can I Use Home Equity?

Get Rid of PMI

A 20% down payment on your home purchase gives you enough home equity to avoid paying for PMI (private mortgage insurance).

If you're already paying for PMI or you don't have a 20% down payment, consider making extra payments towards your mortgage principal.

Once you build 20% home equity, read this article on how to get rid of PMI for the next steps to take.

Increase Your Net Worth

Your net worth can include home equity, so if you're buying another property or getting a loan for something, you may be able to count the amount of equity as an asset.

HELOC vs. Home Equity Loan

Another way you can use it is to get a HELOC which is a revolving line of credit against your home. With a HELOC, you can borrow from it as needed and only pay interest on the amount you use.

Many banks do not allow you to borrow from your equity until you have at least 20%, and even when you have 35% equity, the bank will typically require you to leave at least 15-20%, which means you may only get loan approval for 15% of the equity.

Similarly, you can get a home equity loan as a one-time lump sum and pay it back in installments.

In addition to paying interest, a HELOC and a home equity loan can come with additional fees. Here's a list of costs to ask about when approaching your lender for a HELOC or a home equity loan.

Cash Out Refinance

You can also do a cash out refinance, which is popular with real estate investors. This process allows you to refinance your home, preferably at a lower interest rate, and in doing so, take out the equity in cash. Your equity position will be minimal, but you'll have some money to pay off debt, make a needed purchase, or invest in your next property.

Sell Your Home

Finally, if you would rather not be a homeowner, there's no shame in selling and becoming a renter. You can sell your home and use the equity as you would any other cash. Pay down debt, buy something new, travel, or invest it for the future. And if you're ready to move on, you can sell your home and use the equity as a down payment on your next primary residence.

Pros and Cons of Using Your Home's Equity

Like most things in life, there are definite pros and cons to using your home equity, and here are a few for your consideration.

Get rid of PMI. You can make extra payments toward your mortgage principal to build equity and eventually get rid of PMI. A 20% down payment on future home purchases will allow you to avoid PMI.
You're eligible for a lower interest rate on a line of credit or a loan against your home equity. The interest rate can be better than what you would get for a personal loan. Additionally, the application process may be faster and easier if the borrower is an existing banking client.
With a HELOC, you have the flexibility of only using what you need. Let's say you're approved for a $10,000 home equity line of credit but only need to use $1,000 now for debt consolidation. A few months later, you may need $8,000, and that's fine, too. As long as you remain in good standing, you can access this money again and again with a HELOC.
You can improve your credit score. Your home equity loan will add data to your credit report, and you may see your credit score rise if you're making your monthly payment on time.

Loans against your home equity are not free. A home equity line of credit or loan can come with fees, including an origination fee and an appraisal fee in addition to the interest rate.
As a "worst-case scenario," you risk losing your home if you've borrowed more than you can pay every month. To reduce the risk of this happening, always be conservative in what you borrow.
It's easy to see home equity as free money and then go on to misuse it. Just like a credit card, you have to pay back the loan. Plenty of people have wiped out their HELOC on frivolous things and regretted it afterward. Be sure that you need the money before you borrow it, and limit yourself to spending the loan on something that will improve the value of your home.

Bottom Line

Home equity is crucial if you want to access money for short-term loans. How much equity you start out with depends on your down payment and how aggressively you pay down your mortgage, but remember, there are also factors outside of your control.

When the housing market is down, you may lose equity, but it’s not permanently gone unless you need to sell your home at that time. Responsible borrowing from your equity and keeping an emergency fund is essential to weathering any financial storms that come your way.