What Is Home Equity and How Does It Work?

What is Home Equity?

In short, your home equity is the portion of your home that you own. Equity is usually expressed as a percentage or a dollar amount — the amount your home is worth versus the amount left on your mortgage. 

Calculating your home equity is pretty straightforward. Here’s a simple formula:

current mortgage balance ÷ your home’s market value = % of equity you have in your home

Say, for example, your home is valued at $400,000, and you have $200,000 left to pay on your loan. Therefore, you would have $200,000, or 50 percent, in equity. 

Your home equity rises slightly each time you make a mortgage payment. The longer you make mortgage payments, the quicker your equity increases, thanks to a more significant portion of each payment going toward the loan's principal (the amount you borrowed from your lender) rather than its interest (the fee you pay for the privilege of borrowing). However, it can also fluctuate based on the real estate market and whether or not the value of your home rises or falls. 

How Does Home Equity Work?

Many homeowners use the equity in their homes to pay for more considerable expenses they can't cover out-of-pocket. Lenders allow homeowners to leverage the equity they've built to pay for other expenditures, often at lower interest rates than personal loans. When using your home equity, it's important to remember that the house serves as collateral for both your mortgage and the secondary loan. So if you default on either, your home is in jeopardy.

Using your equity makes sense when you plan to stay in your house for a while. But how does home equity work when selling a home? It’s actually pretty similar to your primary mortgage. You can sell even if there’s an outstanding home equity lien. When the house sells, the proceeds are used to pay off both the mortgage and the secondary lien before you collect any profits. 

How Can You Use Your Home Equity?

In addition to covering purchases that don’t fit into your monthly budget, your home equity can help you strategically avoid higher interest rates. Common uses of home equity include:

• Home improvements. Kitchen, bathroom, and other upgrades make your house more comfortable. They can also increase your home value and help it stand out when it’s time to sell. But the upfront costs can be steep and more easily absorbed over time using equity.
• Emergency expenses. Medical bills, home repairs, and urgent pet care are often unpredictable — and can balloon quickly. Using equity can help you cover these expenses without taking out loans at higher interest rates. 
• College costs. Using home equity to pay for college tuition, books, and living expenses can save you money on interest, as long as loan rates are lower than student loan interest rates. It can also extend the loan repayment period longer than a traditional student loan, allowing for smaller monthly payments.
• Big-ticket purchases. You can save significant interest on pricey items like vehicles, vacations, and other high-dollar expenses by using home equity rather than taking out a personal loan. 
• Wedding expenses. Paying for your dream nuptials or an exotic destination wedding may be more affordable using home equity rather than a wedding loan. 
• Business expenses. Startups, expansions, and new equipment are spendy but can pay off in the long run, so they may be worth dipping into equity. 
• Debt consolidation. Existing car loans, personal loans, or consumer credit card debt can often be consolidated at a much lower rate using home equity. For example, interest on the average credit card fluctuates around 20 percent, while home equity loans are usually less than 8 percent. 

When weighing your options, it’s important to consider how much the new lien will add to your monthly payment. If the extra payment stretches things too thin, find another way to pay. Getting behind on student or auto loans will affect your credit score, but it won’t put your house at risk. 

How Can You Access Your Home Equity?

Short of selling and pocketing the profits, the most common ways to tap into your home equity are applying for a home equity loan, a home equity line of credit, or refinancing with a cash-out option.

Home equity loan

A home equity loan lets you take out a portion of your equity as a lump sum and pay it back in monthly payments, usually over a period of five to 20 years. Also known as a second mortgage, a home equity loan is a separate lien from your initial mortgage. This means you’ll be paying back both loans at once. But, some institutions at least waive your fees and closing costs. So if you need to sell your house with an outstanding home equity loan, you can. Just remember that the proceeds will be used to pay back both loans before you get your share. 

Home equity line of credit

A home equity line of credit (or HELOC) gives you access to cash on demand. But unlike a home equity loan, you only accrue interest once you use the money. Usually, your financial institution agrees to lend you a certain amount and issues you a card for HELOC expenses. The HELOC is a revolving loan, which means you can pay it down and then use it again repeatedly during the draw period (which is usually around 10 years). Most have variable interest rates, so your payments may change based on market conditions. Some institutions may tack on closing costs as well. 

Cash-out refinancing 

Cash-out refinancing lets you use your home equity without adding another lien to your property. Cash-out refinancing will, however, replace your existing mortgage, so your terms will change. In addition, when you refinance, you'll receive a lump sum from the equity you've built. 

Most lenders require you to leave at least 20 percent equity in your home, although some waive this requirement if you pay private mortgage Insurance. PMI usually ranges from about .6 percent to 1.85 percent of the loan annually. So this extra payment and closing costs of 2-5 percent must factor into your numbers if you plan to dip below 20 percent.

You can get a home equity loan, HELOC, or cash-out refinance anywhere you would obtain a primary mortgage, like your local credit union. When you apply, they'll consider your annual income, debt-to-income ratio, loan-to-value ratio, credit score, and the amount of equity you have.

How to Increase Your Home Equity

But what if you’re looking to build, not borrow from, your home equity? Recent conditions have caused prices to skyrocket in many housing markets, giving homeowners instant equity. Overall, U.S. home values nationwide have risen each quarter since early 2012. This is excellent news for those who want to tap into their equity, but it's important to remember that market-based gains aren't necessarily permanent.

It's possible to boost your equity in ways that are guaranteed to last. However, most strategies require you to put more money into your mortgage regularly. Check the terms of your mortgage first, though, because some include pre-payment penalties if you pay off the loan earlier than expected. 

One easy method is paying more than the minimum each month. Doing this funnels more money toward the principal, so you knock the loan out sooner. This can be as simple as increasing the amount of your monthly payment through your lender's website or talking to your lender about the best way to add to your payment. 

You can also ask your lender to switch to a biweekly payment plan. Since the year has 52 weeks, this strategy will give you 26 half-payments or 13 full payments. This gives you the equivalent of a full payment more than the standard 12 monthly payments, so you'll chip away at the principal quicker. Do your homework before making the switch because some financial institutions require extra fees for this option.

If your financial institution penalizes you for extra payments to the point the savings aren't worth it, consider refinancing your mortgage for a shorter term. Remember, this will increase your monthly payment and probably add closing costs. But if you can afford it, paying your home off early can save you thousands of dollars in interest.

Further Resources on Home Equity

It's vital to be proactive when using or managing your home equity. Here are some additional resources on how home equity works:

• Got a college-bound student? The Consumer Financial Protection Bureau breaks down the pros and cons of using a home equity loan as a form of student loan payment. 
• HELOC reduced or frozen? Your lender may reduce or freeze your HELOC if a market turn pushes your equity into the negative, if you lose your job, or if your credit score drops. Some may monitor and unfreeze your account when the situation changes, but you may need to give others a nudge. 
• Having second thoughts about your equity decision? A federal rule gives you three days to reconsider, penalty-free, even if you’ve signed on the dotted line. The three-day cancellation rule applies to most home equity loans and HELOCs that use your primary residence as collateral.

Getting Equitable Help with Home Equity 

Home equity is a valuable asset that homeowners can leverage to achieve their financial goals. And, just like a crown jewel, it requires careful protection and nurturing to maintain its shine. By working with your local credit union to explore home equity options, you’ll be on your way to securing a truly regal financial future.

Did you know?

Credit unions can be an excellent option for tapping into your home's equity, thanks to their cooperative structure, which enables them to offer lower rates and fees to members by passing on their earnings. In contrast, banks are typically driven by profit motives and may charge higher interest rates and fees, making them a less attractive choice for borrowers.