What Does Home Equity Mean?
Your home is your sanctuary. Your retreat. Your safe haven. It can also be a tool you leverage to help achieve your goals, like building an addition or starting a business. It can give you physical shelter today and help protect your financial future. How? Through the use of your home equity. But what does home equity mean?
Simply put, home equity is the amount of your home's value under your control. Keep reading to learn more about how home equity works. And for more tips on home equity, you can contact the experts at your local not-for-profit credit union. Their community-focused approach means you'll often find better rates when ready to tap into your home equity. Find a credit union near you with our Credit Union Locator Tool.
How Home Equity Works
There are two ways your home equity can go up:
- Each time you make a mortgage payment
- When the home’s value appreciates
Early in your mortgage, most of your monthly payment goes toward interest on the loan. Over time, more money goes to the principal as you pay down the interest. So, if you bought your home recently, most of your equity probably comes from appreciation rather than payments.
In fact, appreciation has helped give the average U.S. homeowner an impressive 71% equity in their home. That translates to an average of about $270,000 in value for the typical homeowner.
How Can You Access Your Home Equity?
Home equity isn’t just a number — it’s something you can leverage to achieve real-world goals. There are three main ways to access your equity:
- Home equity loans
- Home equity lines of credit
- Cash-out home refinancing
Home equity loans
When you take out a home equity loan, you receive a lump-sum portion of your home equity. You’ll repay that amount, plus any interest and fees, over the next five to 20 years. This home equity loan does not replace your original mortgage. However, it is sometimes called a second mortgage because you repay it in addition to the original mortgage loan.
Home equity lines of credit (HELOC)
Instead of taking out another mortgage in one lump sum, some homeowners prefer the flexibility of a home equity line of credit (HELOC). But what is a HELOC? It works similarly to a loan but can save on interest if you do not need the total amount at once. A HELOC is what many homeowners turn to when they are still determining just how much of their home equity they will need to access.
A HELOC is a revolving line of credit and functions similar to a credit card, but with the total amount you can charge based on your approved home equity. Also like a credit card, you are only charged interest on what you have spent and can pay that balance down at any time. Unlike a credit card, a HELOC tends to have more reasonable interest rates and will typically not have additional fees for carrying a balance. However, there may be ongoing fees related to transactions or account maintenance.
Cash-out home refinancing
If you already have a mortgage through a preferred lender or want to take advantage of a drop in interest rates, you may want to consider a cash-out refinance. This option is a bit like hitting the reset button on your mortgage. You take on a new mortgage at a current interest rate. That mortgage pays off your existing mortgage, and any balance left is paid to you.
How much you can get from refinancing will depend on your credit score, the equity in your home, and current interest rates. You are getting approved for a completely new mortgage, so it is not unlike purchasing your home all over again, just from yourself, without paying taxes or closing costs.
Whichever option you are considering, it is always important to remember that your home is the underlying security for your debt. The consequences for defaulting, even on a HELOC, are potentially the same as defaulting on any other type of home loan. No matter what you are approved for, make sure you do your own calculations and are ready for the added financial burden of repaying your debts.
Common Ways to Use Home Equity
When used properly, home equity is a great way to cover unexpected expenses or big-ticket items that don't fit your monthly budget. Using your equity can also give you access to much lower interest rates than you'd pay for personal loans or other forms of debt.
Typical uses of home equity include:
- Emergency expense coverage. Home equity can help you cover medical bills, emergency home repairs, and vet bills.
- Home improvement assistance. You can use your home equity to finance upgrades that raise your home's value, such as a bathroom or kitchen remodel. Using home equity financing to make home improvements makes sense since it increases the asset's value used to secure the loan.
- Making large, one-time purchases. If you are planning to take on debt to purchase, such as a recreational vehicle or boat, you may be able to secure a lower interest rate with home equity financing.
- Consolidation of existing debts. If you have a number of different debts with varying interest rates, a home equity loan or refinance may enable you to consolidate those expenses into a single loan with a more manageable interest rate.
- Paying for educational expenses. Tuition, books, living expenses — higher education costs can add up quickly, and a HELOC may have more favorable interest rates than other opinions, like traditional student loans.
- Business investment. Many business owners use home equity to secure loans to buy new equipment, expand their business, or cover expenses during economic downturns.
What Happens to Home Equity When Selling a House?
The proceeds from the sale of your home pay off your primary mortgage. If you have a HELOC or home equity loan, the proceeds will be used to satisfy those liens, too. The rest of the profits — minus any commissions or fees related to the sale — are yours to keep.
However, there are two potential complications sellers need to know if they have an equity lien attached to their home:
- Early repayment fees. Find out whether your lender charges early repayment penalties if you pay your loan off early. This shouldn't be a deal-breaker, but it's something to remember when calculating your potential profits.
- Decreased home value. It can be a bigger problem if your home value has significantly reduced since you took out an equity loan. If the value drops, you may not make enough from the sale proceeds to pay back the mortgage and the equity loan. Although lenders are vested in making the situation work, this scenario often results in a short sale, which hurts your credit rating. And lenders may force you to find another way to pay the balance. This is one reason to be cautious when deciding how much of your home's equity to use.
Growing Your Home’s Equity
Real estate is generally considered a good investment because land almost always becomes more expensive over time. In addition, mortgages are usually paid off over decades, meaning that even inflation has time to decrease the cost of investment compared to the ultimate resale value. There are ups and downs and even housing bubbles that eventually burst, but while market factors may decrease your profit from selling a home, most home values go up in the long term.
At the same time, you should remember that land is what really appreciates, not your home itself. The land your home sits on becomes more valuable, but your home will deteriorate without constant upkeep and maintenance.
While you cannot do much to impact the value of your property, which will shift based on external economic factors, there is plenty you can do to increase the value of your home. One of the most common ways homeowners add equity to their homes is by making improvements.
Regarding resale value, the most common areas people focus on are bathrooms and kitchens. However, you should also be mindful of projects that protect the overall investment, such as insulation, roofing, and windows. Keeping your home in good condition can go a long way toward securing its value in the long term and also help avoid costly repairs down the road.
You may also consider significant construction projects, such as building an addition, remodeling the attic or basement to add living space, or adding amenities like a pool or patio. With each improvement, it is a good idea to consult an expert to ensure your investment adds as much value as you are paying for it. New construction costs may cost more than the equity they add.
Paying down the mortgage
If you have a mortgage, paying it down can be one of the most direct ways to increase your home equity. This can be especially true if you purchased at a higher interest rate. Check your mortgage terms to determine whether you can make additional payments toward the principal each month. Most lenders will permit this, but may have specific requirements for how and when the additional payment is made to ensure it goes toward the principal rather than interest.
You can also ask your lender about switching to a biweekly payment plan. Changing the payment schedule doesn't seem like much, but it gives you the equivalent of another full monthly payment over a year, cutting down on the interest you'll pay over time. Of course, the lender makes money by charging interest, so they may tack on early repayment fees to compensate for the potential loss. Check the fine print before you switch. If the penalties for paying your loan off early outweigh the advantages, you may want to investigate refinancing terms.
If you receive extra or unexpected income, such as bonuses, tax returns, or gifts, consider using them to pay down the loan balance. As with any form of paying down your loan, you will need to know your prepayment penalties before adopting this strategy.
Further Resources on How Home Equity Works
Leveraging your home equity is a big decision. It has many advantages, but it’s not without risks. Make sure to do your homework before signing on the dotted line, even with a trusted lender. Investigate your options so that you truly understand what home equity means and how to use it. You can start with these additional resources:
- Weigh the pros and cons. Deciding whether using your equity for a purchase is a good idea? Weigh these recommendations from a group of not-for-profit financial counselors.
- Don’t procrastinate. After reaching near-record numbers in 2022, equity opportunities have slowed, but interest rates are not expected to decrease any time soon.
- Look for red flags. Not every lender has clients’ best interests in mind. The Federal Trade Commission issues these warning signs for borrowers to avoid.
Take Your Home From Castle to Capital
So, what does home equity mean? Well, if your home is your castle, it can also be your vehicle loan, college tuition, or business startup seed, thanks to your home equity.
Using home equity responsibly can help you get ahead while shoring up your financial future. To learn how to put your equity to good use, use our Credit Union Locator Tool and reach out to the home equity experts at your local credit union today!