How Home Equity Works: 4 Common Ways to Use Home Equity

Home equity is the difference between a home’s current appraised value and the size of its mortgage. As homeowners make payments toward their mortgage, they begin to build equity, a valuable asset that can serve as leverage when applying for loans or lower mortgage costs. For example, if a home’s fair market value (the price the home can potentially sell for) is $700,000 and the balance of the mortgage loan is $350,000, then the homeowner has accrued $350,000 in home equity. If a homeowner pays off the mortgage loan, their equity is 100 percent of the home’s current value, minus any outstanding property taxes or liens.

The housing market primarily drives equity, which means the home’s value is ever-changing. Home value can decline for many reasons, including rampant foreclosures in the neighborhood, business relocations, or homes in the area selling for lower prices. Conversely, the value of a home can climb due to high-value home renovations, when attractive businesses relocate into the area, or housing demands outpace the supply in the area.

Home equity works as a growing pool of wealth—in general, here’s how the system works:

1. 1. Home equity increases. As a homeowner makes mortgage payments or renovates the home, their home equity increases, which means they can accrue more money to borrow to pay off necessary expenses.
2. 2. The homeowner qualifies for a home equity loan. After accruing enough equity, homeowners can apply for a home equity loan or line of credit by using their equity, credit score, loan-to-value ratio, and debt-to-income ratio as leverage. In general, these borrowing options offer homeowners a lump sum of money upfront with lower interest rates or annual percentage rates (APRs) than personal loans or credit cards.
3. 3. The homeowner spends the loan funds. Homeowners can use borrowed money for many purposes, including home improvement costs, college tuition, medical expenses, debt consolidation (especially high-interest debts), or purchasing a new home or second property.
4. 4. The homeowner pays back the loan. After spending the loan funds, homeowners can begin making payments toward the loan amount or credit line in regular installments. However, home equity borrowing comes with risks—if a borrower fails to pay back the loan balance, they run the risk of the bank foreclosing on their own.

Home equity is the simple difference between a home’s total value and the size of its mortgage, so homeowners can build equity by either increasing the value of the home or decreasing the size of the mortgage:

1. 1. Make a sizeable down payment. The down payment that homeowners make when they first purchase a property serves as the first sum paid toward the home’s equity. A larger down payment means a smaller total mortgage, meaning they’ll accrue more equity sooner.
2. 2. Make consistent mortgage payments. Making regular mortgage payments decreases the size of a mortgage and increases home equity.
3. 3. Renovate your home. Remodeling, adding on attractive features like a mudroom, mother-in-law suite, or basketball court can increase the home’s value, giving the owner a larger amount of leverage to borrow against.
4. 4. Wait for the market to fluctuate in your favor. As the housing market fluctuates, the house’s value will rise and fall. When the real estate market is on the rise, home prices and property values will increase, and the owner will have a larger amount of equity.

Once a homeowner has built enough equity in their home, they can take advantage of a few borrowing or loan options with different terms:

1. 1. Cash-out refinance: For a cash-out refinance, a homeowner negotiates a new mortgage with a new mortgage lender and receives a lump sum to pay back the original mortgage, keeping the difference. Refinancing usually has lower interest rates than home equity loans (HELs) or home equity line of credit (HELOC) but higher closing costs (including application fees and appraisal fees).
2. 2. Home equity loan: Home equity loans are fixed-rate second mortgages, with fixed interest rates and fixed monthly payments over the life of the loan. These loans don’t typically have an annual fee. Certain expenses can be tax-deductible.
3. 3. Home equity line of credit: Home equity lines of credit are variable-rate loans similar to credit card debt, with a “draw period” that you can borrow against at any time within a specific credit limit according to the loan terms. Once the draw period ends, it’s followed by a “repayment period.” HELOCs have variable interest rates and usually come with an annual fee. Certain expenses can be tax-deductible.
4. 4. Reverse mortgage: This type of home equity loan is specifically for senior homeowners who are 62 and older, and allows them to convert their equity into cash payments. Reverse mortgages do not typically have to be repaid so long as the homeowner lives in the dwelling, though this depends on the lender’s terms. If the homeowner moves, they must repay the loan. If they pass away, the heir to their estate will have to repay the loan.

Home equity is the simple difference between a property’s total value and the mortgage loan size. To calculate home equity, simply take the home’s current market value and subtract the home’s total remaining mortgage balance. Here’s the formula:

Current appraised market value - mortgage balance = home equity

For instance, if the current market value of your home is $300,000 and you still owe $100,000 on your mortgage, your home equity would be $200,000.

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