Equity is a term that you may encounter when dealing with financial matters. It is easy to understand, and if you have equity in your home, you may be able to qualify for certain types of loans that have special benefits.
WHAT IS HOME EQUITY?
Home equity refers to the amount of your home that you own. It is the market value of your home less the amount you still owe on your loan (not counting interest and fees).
For example, let’s say you recently purchased a $300,000 home and made a 20% down payment of $60,000. Immediately after you close on the loan, you will have $60,000 in home equity.
Home equity can increase in two different ways. First, it can increase if the market value of your home increases. Let’s use our previous example of buying a $300,000 home again. If the market value increases to $350,000, your home equity will then be the amount of your down payment plus the market value increase ($60,000 + $50,000), or $110,000.
Home equity also increases as you make regular monthly payments on your mortgage to repay the principal. Let’s assume you made a $60,000 down payment on a $300,000 home and it has increased in value by $50,000, as in the previous two examples. If you live in your home for 10 years and repay $100,000 of the principal in that time, then your home equity will be $210,000 ($60,000 + $50,000 + $100,000).
One very important thing to keep in mind with home equity is that the real estate market constantly fluctuates. Homes tend to increase in value each year from 3.5% to 3.8%, although they may go down in value, too. It’s also possible for homes to lose a great deal of value (and home equity) in dire economic times, like during the Great Recession.
HOW DO YOU CALCULATE HOME EQUITY?
Determining how to calculate your home equity is a simple process that can be completed in three steps.
1. Determine the Current Market Value of Your Home
The first step is to find out what your home is worth. This may be a different amount than the price you paid for it if you’ve lived in your home for a few years.
Some real estate websites, like Redfin, will give you an estimate of the current market value when you enter your address. A local real estate agent may also be able to help you with this.
It’s important to keep in mind that the figures you obtain will be estimates. If you apply for a home equity loan, your lender may use a different estimate when determining how much you can borrow.
2. Determine Your Mortgage Balance
The next step is to find out how much you still owe on your mortgage. The payoff amount may be found on a recent mortgage statement. You can also obtain the payoff amount by calling your lender and asking.
3. Calculate Your Home Equity
You can now calculate your home equity by subtracting your mortgage balance from the current market value.
HOW CAN YOU BENEFIT FROM HOME EQUITY?
If you have equity in your home, you can use it to obtain a secured loan to use for a home remodeling project, to have as an emergency backup, or for something else.
There are three types of loans you can obtain using your home’s equity as collateral. Each loan has certain advantages to consider.
Home Equity Loan
Home equity loans are sometimes called second mortgages and are structured similar to your primary mortgage. These loans have fixed interest rates.
With a home equity loan, you receive a lump sum payment upfront for the money you borrow and then repay it over time with fixed monthly payments. There are usually no restrictions on what you can use the money you borrow for, and the repayment terms may be longer than other loans.
Home Equity Line of Credit
A home equity line of credit (HELOC) is another type of loan that is backed by the equity in your home. These loans are very different from traditional loans.
With a HELOC, instead of receiving a lump sum upfront and then repaying it with fixed monthly payments, you receive a line of credit that you can draw from as needed. You can withdraw enough money to buy building materials to start working on a home renovation project, for example, and then borrow some more later to finish the project.
A HELOC will have a credit limit. Similar to a credit card, you can replenish your available credit by repaying the money you borrowed.
One thing that many people like about HELOCs is that you only have to make interest-only payments during the draw period. The principal will be due when the draw period ends.
With a cash-out refinance, you obtain a new loan to replace your current loan. However, instead of only borrowing enough money to pay off your current loan, you borrow more than the payoff amount and use the extra for other purposes. The extra money you borrow is backed by the equity in your home.
A cash-out refinance loan is a great option if interest rates are lower than when you obtained your current loan. The extra money you obtain from these loans (the cash-out) can be used for many different purposes.
WHICH LOAN IS BEST?
The three different types of loans that use home equity as collateral are best suited for different situations.
Home equity loans are best for when you want to repay the money you borrow with predictable monthly payments. HELOCs make sense for when you need to periodically borrow money and you don’t know exactly how much you will need.
Finally, a cash-out refinance is a great option for when interest rates decline. You can save money on interest by refinancing your mortgage and borrowing the extra money you need at the same time.
If you aren’t sure whether a HELOC or home equity loan is best for your needs, the following article provides an in-depth comparison to help you decide.