Home equity, which is the current value of your home less the outstanding balance on your mortgage, is important because it enables you to amass wealth. You can borrow money when you have equity in your home to make improvements to it or pay off other high-interest debts. But it’s also unstable because home values fluctuate constantly, sometimes wildly. You’ll need a steady income and good credit in order to qualify for a home equity loan.
The majority of people’s household wealth is made up largely of home equity. Black and Hispanic households, which “have seen outsized gains in housing wealth over the past decade,” are particularly affected by this, according to the Federal Reserve.
By the end of 2023, home equity accounted for roughly 28% of the wealth of Hispanic families and 20% of the wealth of black families, compared to 16% for white families. The percentages are high in part due to the booming housing market over the past ten years and in part due to the fact that black and Hispanic families, who are generally poorer than white and Asian families, have a higher percentage of their wealth invested in their homes.
What is equity in a home?
Home equity, which can be either positive or negative, is the difference between your home’s current market value and the amount still owed on your mortgage. When it’s positive, you can usually access up to 80% of the value of your home, which can be crucial if you don’t have many other assets (such as stock holdings and cash emergency funds, for example). Furthermore, it serves as a safeguard in case of a market downturn that might otherwise prevent you from selling your house.
Selling your house won’t be enough to cover your mortgage if you have negative equity. This is how many homeowners during the Great Recession were pressured into short sales or foreclosures.
Your mortgage principal and the regional housing market are two factors that affect your home equity. In a perfect world, your equity would rise as you paid off your mortgage. This is due to the fact that your equity is equal to your home’s value less your outstanding mortgage. That’s not the case, though, if the value of your house is dropping.
Uncontrollable variables affect the demand for homes in your neighbourhood and your property value, which affects whether your equity declines, stabilises, or grows over time.
Think of San Francisco, Los Angeles, Denver, and Seattle to get an idea of how housing shortages in many markets have driven up home prices (values) in recent years. According to the National Association of Realtors, the number of homes for sale nationwide is at an all-time low.
Your home’s value, however, might be declining if you reside in a city with an ageing housing stock and a declining population. Your home equity may be decreasing even as you pay off your mortgage.
Although you have no control over the state of the housing market, there is one thing you can do to try and maintain the value of your home: maintain it. Except for some real estate investors who prefer neglected properties, a home that is clean, cosy, and well-maintained is always more desirable than one that isn’t.
Home equity can be increased in two ways:
increase in the value of homes Your house gains in market value, or the price at which you could sell it.
principal reduction on the mortgage. As long as the value of your home is stable or rising, as you reduce your mortgage principal, your equity grows.
With each monthly payment you make, you build equity more quickly the longer you’ve had your mortgage. You can see that at the start of your loan term, the majority of your payment goes towards interest by looking at an amortisation schedule for a mortgage. You owe less money overall and pay off less interest with each payment. The remainder of your subsequent payment is then applied to the principal.
To determine your home equity, follow these four steps:
Use a tool online or recent sales of nearby properties to determine the estimated market value of your home.
To find out how much principal you still owe, check your most recent mortgage statement.
Use the following formula to deduct your mortgage balance from the value of your home:
Home value minus the mortgage balance equals the amount of home equity.
Use the following formula to determine your home equity percentage rather than just the total amount:
Home equity is calculated as (home value minus mortgage balance)/home value.
Here are a few illustrations to clarify the math.
Equity in one’s home is a useful asset. You can technically use the money however you want if you borrow against it. But it’s typical to use it for bigger costs like house renovations, higher education, debt reduction, or relocation.
With a home equity line of credit (HELOC), you can borrow up to 80% to 85% of the value of your house. You can on a line of credit as needed rather than making a one-time payment. Only the amount you borrow will be subject to interest, and interest rates are subject to change.
With a home equity loan, you can get a lump-sum payment of up to 85% of the value of your home, unlike with a line of credit. Depending on your particular loan terms, you may have to pay interest on the entire amount and repay the loan within five to thirty years. A home equity loan is a good option if you know how much money you need to borrow and want the security of a fixed interest rate.
Refinance with Cash-Out
When you want to refinance your current mortgage to get a lower interest rate or access additional financing for other expenses, a cash-out refinance can be a good way to access your home equity. It replaces your current mortgage with a new, larger mortgage and permits you to borrow up to 80% of the value of your home. You receive the difference between your old and new mortgages in the form of money.
Homeowners who are at least 62 years old and have little or no mortgage debt can use a reverse mortgage. These mortgages enable you to obtain a loan that you might never be able to repay by borrowing against your significant equity. When you move or pass away, your heirs will instead list and sell your property to recoup the reverse mortgage balance.
Deposit for a New House
Some people start out by purchasing a less expensive home, then, when their finances are more stable, they sell and upgrade. When you sell your current home, the equity you’ve built up over the years as a homeowner can be used as a down payment for your new one.
Return to renting after selling.
Some people decide homeownership is not worthwhile after having the experience. Home maintenance can take a lot of effort and resources. You can cash out all of your equity when you sell it and put it to any use you choose.
Benefits of Applying Home Equity
- You can get a loan with a low interest rate if you use your home as collateral.
- In comparison to other forms of borrowing, interest rates are low.
- The money can be applied to just about anything.
- If you itemize deductions, interest might be tax deductible.
- Depending on your total equity, you can typically borrow up to 85% of the value of your home.
Cons of Applying Home Equity
- If you don’t pay back a home equity loan, you risk losing your house.
- To use your equity, you must pay interest and loan fees.
- It puts an end to your quest for debt-free homeownership.
- You might not save much money by breaking down the interest on your home equity loan.
- Because loan eligibility is based on the state of the market, your income, and your credit, you might not be able to access your equity when you most need it.