What is Home Equity and How Do You Use It?
If you’re a homeowner wanting to understand your home equity, it’s important to understand what equity in your home means, how to calculate the equity in your home, how to cash in on your equity, and some ways to spend the money you get from your home.
What is Home Equity?
When you buy your home, you are acquiring a mortgage, also known as a mortgage loan, and in essence, you are going into debt. However, homeownership is a good type of debt, because your home is an investment that grows in equity. There are three ways this typically happens. The first is, as you pay money toward your mortgage, you pay off the amount owed, creating equity. The second is, as home values increase, the amount you owe becomes far less than what the home is worth, again creating equity. The third is doing home improvement projects that increase the value of your home.
To determine the equity in your home, you need to know the fair market value of your home, then subtract the balance of your mortgage. This equals the amount of your home equity.
Let’s look closer at how this subtraction equation helps determine home equity . . .
How to Determine Equity in Your Home
When trying to understand and determine if you have equity in your home, the subtraction equation above is essentially looking at two factors to figure out the percentage of your home equity:
- What do you still owe before your home will be paid off? Your loan-to-value ratio is your current mortgage balance divided by the current market value of your home.
- What is your home worth? The fair market value of your home is what is your home is currently worth. This can be assessed by comparing your home to similar homes that have sold in your area.
When a home’s fair home market value is less than your current mortgage balance, you do not have any equity in your home. When the fair market value of a home is greater than your current mortgage balance, the equity in your home is considered positive.
How to Calculate Home Equity
Having positive equity in your home is a great step toward being able to borrow from it. Beyond having positive equity, lenders often require that you have a minimum of an 80% loan-to-value ratio in order to be approved to borrow from your equity. Let’s use an example to demonstrate how to calculate your home equity.
If your home’s current fair market value is $300,00, and your current balance on your mortgage is $200,000, here’s what your home equity calculation would look like:
- Current fair market value of your home: $300,000
- Multiply the current value of your home by a loan-to-value ratio of 80%: ($300,000 x 0.8) = $240,000
- Subtract current mortgage balance: ($240,000 – 200,000) = $40,000 equity
You can calculate your own home equity to determine how much you can borrow against your home using the same equation, or you can use our home equity calculator.
How to Get Equity Out of Your Home
The amount of your down payment is usually the first step in the process of developing your home equity. If you used an FHA or conventional loan, then your down payment may be as low as 3.5% or as high as 20%, respectively. Outside of your initial down payment, here are seven other ways to build and grow your home’s equity:
- Large down payment: If you can, put down a larger down payment. If you are applying for an FHA loan because of credit reasons, but have the money to put down more than 3.5%, put it down on your home. If you are getting a conventional loan, and have the ability to put more than 20% down, do it!
- Home appreciation: Over time, your home’s value will likely rise due to the changes in the market.
- 15-year mortgage: When possible, apply and get a 15-year mortgage over a 30-year mortgage. 15-year mortgages usually come with a lower interest rate.
- See your 30-year as a 15-year loan: If you have already locked in a 30-year mortgage, calculate what it takes to pay off your mortgage in 15 years. If you can afford that payment, then start paying that amount every month.
- Bi-weekly payments: Getting on a biweekly payment plan where you are paying 26 payments instead of the traditional twelve payments a year is a great option.
- Principal only payment: After making your typical monthly mortgage payment, make an extra payment every month that you direct to the principal of your mortgage.
- Home improvements: Doing home improvement projects will add value to your home, add equity, and increase your family’s overall satisfaction level in the home.
You may also want to consider ways to pay down your mortgage faster to build more equity in your home.
How to Cash in on Your Home’s Equity
When cashing in on your home equity, there are two main types of loans you can choose from:
- Home equity loan: A lump sum of funding that’s taken from your home’s equity.
- Home equity line of credit (HELOC): A revolving line of credit linked to your equity.
When deciding which is best, it’s a good idea to compare the pros and cons between a home equity loan vs HELOC. You’ll have a better understanding of the differences between the two and why you’d want to choose one over the other. No matter which you choose, here are the ten steps to applying for your loan:
- Know your credit score: When you apply for an equity loan or line of credit, the interest rate you will be given is based on your credit score. You can check your credit score for free. If you check your score and find errors, have them fixed prior to moving on in the process of getting an equity loan or HELOC.
- Get an appraisal: Find out the value of your home. This will help in accurately determining your percentage of equity. If you do not choose to pay for an appraisal, try and figure out what your home is worth.
- Do research: What are the current interest rates being offered by lenders for home equity loans and HELOC’s?
- Shop around: Contact as many lenders as you can to get quotes. LendingTree can help you by matching you with lenders.
- Evaluate quotes: What interest rates, fees, and terms is each lender offering you?
- Choose: Choose the best equity loan or HELOC based on your comparison.
- Apply: Once you have determined which lender is offering you the best deal for an equity loan or HELOC, apply for it.
- Get approved: Go through the loan or line of credit approval process, and complete all paperwork.
- Receive funds: Receive the funds from your equity loan or line of credit.
- Make payments: Make payments toward paying off the equity loan every month or the amount you use from you HELOC. They are both second mortgages and liens on your home. Making late payments or not paying them back could lead to foreclosure on your home.
Now that you know how to cash in on your home’s equity, let’s look at how you might use it . . .
How to Use Home Equity
From these six ways to use your home’s equity, to using a HELOC as an alternative to credit card debt, there are many reasons and ways to use your home’s equity. Here are nine to consider:
- Home Improvements: Remember how home improvement projects can add to your equity by increasing your home’s value? Using your equity is a great way to fund such projects. Renovating your home is one of the best ways to add value to your home.
- Plastic or cosmetic surgery: Using a home equity loan or HELOC to pay for plastic surgery or cosmetic is one of many options you may consider for financing a procedure.
- Starting a business: Funding is needed when launching a business and a home equity loan or HELOC can help. A home equity loan can act as a small business loan and a HELOC can act as a business credit card.
- Wedding: Paying for a wedding shouldn’t be overwhelming. You should be able to experience the day with peace of mind and happiness. If finances are stressing you out, an equity loan or HELOC might be just the thing.
- Higher education: If you have children nearing college age, or you want to continue your higher education, home equity may be the way to pay for it. If you are thinking of using your equity for education, weigh the pros and cons of using your home’s equity over a student loan.
- Infertility: Infertility is not an easy journey, and treatments can be expensive. Consider your equity loan or HELOC when searching for funding options.
- Adoption: Infant domestic adoptions and international adoptions both bring great joy to families, yet the costs can be very high. Using an equity loan or HELOC can alleviate the financial stress of the adoption process.
- Consolidate debt: Use your equity to consolidate debt, and make your monthly payments more affordable. Before choosing this option, consider whether or not you’re truly ready to use a HELOC for debt consolidation.
- Invest: Use your home’s equity for other investments to add to your overall financial stability.
- Vacation home: Have you always wanted a vacation home? Use your equity to secure the vacation home of your dreams. Just remember that you’ll be taking on another mortgage and conditions may be slightly different than they were for your first mortgage. If you choose to use equity to obtain your vacation home, consider supplementing other options to make your mortgage on your second home more cost efficient.