What Is Home Equity?
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Most homeowners now have more equity in their homes than they did two years ago, thanks to surging home values during the pandemic. That means right now is a good time to consider tapping into your home equity if you're looking to borrow money at a lower interest rate than you might get with other types of loans such as personal loans. Home equity is the difference between what you owe on your mortgage and the current market value of your home.
You build equity in your home by consistently making mortgage payments over the years. Equity is valuable because it allows you to borrow money against your home at lower interest rates than other types of financing. Once you have enough equity built up in your home, lenders and banks will allow you to borrow against it. Some of the most common reasons to borrow against your equity are to pay for life expenses such as home improvements, higher education costs such as tuition, or to pay off high-interest credit card debt.
Most lenders want to see that you've built up at least 15% to 20% in equity in order to let you borrow money against your house in the form of refinancing or other kinds of home equity loans. One of the simplest ways to ensure you have a good chunk of equity in your home is to make a large down payment if you are able to.
For a typical homeowner with a 30-year fixed-rate mortgage, building up 15% to 20% usually takes about 5 to 10 years. Even if you paid less for your home when you bought it years ago, your equity is based on the present-day value of your house. If, for example, your home is currently worth $500,000 and you have $400,000 left to pay on your mortgage, you would have $100,000 of equity in your home.
Here's what you need to know about home equity, what it is, how to calculate it and why it's important to homeowners.
How do you calculate home equity?
To calculate your home equity, simply subtract your remaining mortgage balance from the current market value of your home. So if you owe $400,000 on your mortgage and your house is worth $500,000, you have $100,000, or 20% equity in your home. You may need to work with an appraiser or real estate agent in order to get an accurate evaluation of your home's fair market value, especially since home values have risen by record-breaking amounts since the beginning of the pandemic.
Ways to borrow against home equity
There are various ways to access the equity in your home. Some of the most common equity financing options are home equity loans, home equity lines of credit (or HELOCs) and reverse mortgages. It's important, however, to keep in mind that all of these options require you to put up your home as collateral to secure the loan, so it's critical to understand that there's a risk of losing your home to foreclosure if you miss payments or default on your loan for any reason.
Home equity loan
A home equity loan lets you borrow money against the equity you've built in your home and provides you with a lump sum of cash at a fixed interest rate. Lenders typically want to see that you have at least 15% to 20% in your home to approve you for a home equity loan. A home equity loan doesn't replace your mortgage like a refinance, rather, it's an entirely new loan that you'll repay monthly along with your existing mortgage payment. But just like a mortgage, with a home equity loan, your interest rate never changes and your monthly payments are fixed, too.
HELOCs
A home equity line of credit, or HELOC, is a type of loan that lets you borrow against the equity you've built up in your home and functions like a credit card. It provides you with an open line of credit that you can access for a certain amount of time, typically 10 years, followed by a set repayment period, which is usually 20 years. Lenders also generally want you to have at least 15% to 20% in your home for HELOC approval. With a HELOC, you don't have to take all of your funds out at once, and you can withdraw money repeatedly from your HELOC over the 10-year period, once previously borrowed sums are paid back.
"A HELOC offers more flexibility than a home equity loan -- you can't withdraw money from a home equity loan like you can with a HELOC, and a HELOC allows you to receive replenished funds as you pay your outstanding balance," said Robert Heck, VP of Mortgage at Morty, an online mortgage marketplace.
HELOCs have variable interest rates however, so it's important to make sure you can afford higher monthly payments if your rate goes up once your introductory interest rate expires, especially in the current economic climate.
Reverse mortgage
You must be 62 years or older to access a reverse mortgage and have either paid off your home or have significant equity accumulated, usually at least 50%. With a reverse mortgage, you do not have to make monthly mortgage payments and the bank or lender actually makes payments to you. You must still pay your property taxes and homeowners insurance and continue to live in the house, however. A reverse mortgage allows you to access the equity in your home and not pay back the funds for an extended period of time while using them for other expenses during retirement. It's important to keep in mind that you are building a mortgage balance back up as you borrow against your equity, and your estate will eventually have to pay off your loan. A common way to repay this loan is to sell your house.
The bottom line
Unlocking the equity in your home can be a valuable way to access financing to cover other life expenses. It's important to understand the differences between the kinds of equity loans available to secure the best one for your particular financial situation. When comparing ways to access equity, always take into account the interest rate, additional lender costs and fees, and the size of the loan and how it will be disbursed to you, as well as the amount of time you have to pay it back, before you enter into an agreement to borrow against the equity in your home.
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