Home equity. You’ve heard the term, but what exactly is it and how do you know what it really means for you and your financial outlook?
Home equity is an asset, possibly one of the most valuable you’ll have in your lifetime. Since you may want to be able to use your home equity for a second mortgage or home equity loan, it’s critical you understand what it is and isn’t. Let’s take a closer look at home equity and what it means for you.
On the most basic level, home equity is the portion of your home value that you own. If you took out a loan to buy your property, it’s the difference between the home’s fair market value minus the outstanding balances of all loans or liens on the property. Home equity is something that builds over time and can be used in a variety of ways.
Let’s use an example to make home equity clear. Pretend you bought your house for $400,000 and put down $80,000, securing a loan for the rest of the amount. On day one, your home equity is $80,000, or 20 percent. Your lender never owns the other portion – you own the house. Instead, the house is collateral for your loan.
So, how do you figure out how much equity you have in your house at any given time? Start by figuring out your home’s value. Although only a professional real estate appraiser can give you an official valuation, you can look at comparable home sales in your area to get an idea.
Once you have an official or estimate home value, subtract the amount you owe on all the loans secured by your house from its value. This number is your home equity.
Over time, as you make monthly payments on your loan, you increase your home equity. The majority of home loans in the United States are standard amortizing loans. This means you make a flat monthly payment that goes toward both your interest and principal. Through the years, the percentage applied to the principal repayment gets larger. This means you build equity at an increasing rate each year. That’s great news!
You can also build home equity if your home increases in value. The amount you owe on your loan stays the same, but the fair market value of your property is greater. Here are some more details on how you can build home equity:
Without having to do anything, you may see an increase in property value from a healthy market or a positive change in your neighborhood. This is the easiest way to increase your home equity.
Another way is through home improvements and making an investment in your property that will increase its value. This could be anything from a kitchen renovation to installing a new garage door. You’ll want to do some research on which home improvement projects offer the biggest return on investment, because you’ll have upfront costs associated with any renovations.
Be sure you maintain your property because problems like foundation issues or a leaking roof can actually decrease your home’s property value, and therefore your home equity.
If you have a 30-year mortgage, consider refinancing to a 15-year loan so you can pay off your mortgage in half the time while building home equity. Keep in mind that if you choose to go this route, you’ll likely need good credit, a certain amount of equity in your home already and a low debt-to-income ratio.
Check your credit before you apply for refinancing so you know whether this is an option for you.
Consider making extra payments on your mortgage each month or from time to time to pay down your loan faster. Just make sure your lender is applying the extra money toward your loan’s principal, not interest. You’ll be surprised how quickly this extra can add up and increase your home equity.
In addition to building your equity, making extra payments can save you hundreds or even thousands of dollars in interest. You can use this excess cash toward other things like saving for retirement or college or a nice vacation.
If you don’t need to use your home equity in the near future, you can simply sit back and wait until the value of your home increases on its own. It will more than likely happen naturally as the housing market adjusts and home prices go up. Of course, home prices can go down, as well, and decrease your home equity, so there are no guarantees with this strategy.
Like we said above, your home equity is an asset. If you’re wondering how to use home equity, know that there are many ways you can spend it, or you can choose to leave it to your heirs.
Commonly, people use their home equity when they decide to buy another house. You can put the equity you’ve built up toward the purchase, meaning you’ll have to borrow less.
Some people choose to borrow against their home equity with a loan, which is known as a second mortgage. This can be used to fund things like home improvement projects, college tuition or to cover an unexpected expense like medical bills.
Home equity loans allow homeowners to borrow against the value they’ve built up in their home. They are lump-sum loans that are repaid with a flat monthly fee over a fixed period of time. The interest rates on home equity loans are usually fixed.
With a fixed interest rate, you’ll find it easier to budget for your monthly payments. The greatest drawback of a home equity loan, however, is that it comes with the same types of closing costs you can expect with a traditional mortgage. If you don’t want to borrow too much money, these closing costs can be problematic.
The second is a home equity line of credit, similar to a credit card. You have a line of credit to access as needed during the “draw” period, making smaller monthly payments during this time. Once that “draw” period is up, say after 5 years, you’ll enter the repayment period, which usually features bigger monthly payments. The interest rates on home equity lines of credit are typically variable.
Perhaps the most noteworthy benefit of a HELOC is that it offers incredible flexibility as you get to withdraw money when you need it and only pay interest on the amount you use. Some lenders also offer to take care of closing costs with HELOCs, making them more affordable.
The downfall of a HELOC is its variable rate that can cause your payments to fluctuate. If your payments go up and you don’t have the money to cover them, this can be an issue.
Home equity is an important part of your total net worth, and understanding what it is can make it work for you. Once you understand the importance of home equity, you’ll be equipped to sell your home or buy a new home with the help of educated decisions. And if you’re wanting to save as much money as you can throughout the buying or selling process, ForSaleByOwner.com can help you find success without incurring the costs associated with using an agent.
