Home equity is your home’s value minus what you owe on your loan. It’s like having built-in savings! This opens doors for options like a home equity loan or a cash-out refinance.
Owning a home is a powerful way to build wealth over time. The key is building equity, which essentially turns your mortgage payment into an investment in your future. As you pay down your loan, the portion of your home you truly own (your equity) grows, building long-term wealth.
What is home equity?
Home equity is the present market value of your home minus any outstanding debt. You can build equity by:
- Paying down the principal on your loan.
- Benefiting from an increase in market value over time, which can result from property appreciation and any home improvements you undertake.
How does home equity work?
When you buy a home with a mortgage, both you and your lender share ownership. Your down payment represents your share, while the lender holds the remaining portion. For instance, a 20% down payment means you start with 20% equity in the home.
As you pay down the principal, your ownership share increases and the lender’s share decreases. Building home equity is similar to investing in a long-term asset like bonds; your money is largely tied up and not easily accessible until you sell the home. However, there are ways to tap into your equity and convert it to cash while you still own the property.
Home equity loan
A home equity loan is a type of second mortgage that converts a portion of the equity you’ve built in your home — usually up to 80% — into debt, providing you with a lump sum of cash. You can use this money as you wish, but it’s wisest to invest in expenses that will enhance your wealth, such as financing home improvements like installing central air conditioning.
You repay the loan at a fixed interest rate over a specified term, typically 20 or 30 years. Since the loan is secured by your home, the interest rate is usually lower than that of unsecured loans like personal loans or credit cards. However, this also means that failing to keep up with the payments could result in foreclosure and the loss of your home.
Home equity line of credit (HELOC)
A HELOC operates similarly to a home equity loan but with some important differences. Instead of receiving a lump sum, a HELOC converts your equity into a line of credit that you can draw from up to a predetermined limit. This flexibility is ideal if you’re unsure how much you’ll need to borrow or if you’re financing multiple projects.
Additionally, HELOCs usually (though not always) come with a variable interest rate, which fluctuates with the market over time. You typically have 10 years to draw from the line of credit, followed by a repayment period during which you pay back the borrowed amount.
Cash-out refinance
A cash-out refinance lets you replace your current mortgage with a new, larger one, allowing you to take out extra cash from your home equity. This new mortgage pays off your old one, and you get to keep the remaining balance.
This option is popular with homeowners who have a higher interest rate on their existing mortgage than current rates or who want to change their loan terms, like extending the repayment period.
How do you find out how much equity is in your home?
A home equity calculator can estimate your home’s value and the amount of equity you have if you’re considering selling or borrowing against it.
For a more precise valuation, you can get an appraisal to determine your home’s exact worth.
Why is home equity important?
Home equity can be a long-term wealth-building strategy.
As you make mortgage payments, you reduce your debt while your home’s value increases, earning it the nickname “a forced savings account.” Unlike other loan-financed purchases like vehicles, which usually depreciate, your home typically appreciates in value. Additionally, your home is likely to be one of the most valuable assets you own.
Home equity takes time to build
Time is another factor that contributes to the growth of home equity wealth. Homeowners who remain in their homes for extended periods are more likely to accumulate equity.
There’s a conventional guideline called the “five-year rule” for prospective home buyers. This suggests that homeowners should plan to stay in their homes for at least five years to build enough equity to cover their initial purchase expenses when selling. If the market slows down when you’re considering selling, it might be beneficial to wait until conditions improve, allowing you to sell at a higher value.
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