A home is usually one of your most valuable assets, largely because it builds equity over time. In the right circumstances, you can use that equity to further your financial goals, but that comes with a certain amount of risk. Knowing what home equity is and how it works is essential to protect such an important investment.

What is home equity?

In simple terms, home equity is the value of a home minus any balances owed against it. It’s the current appraised market value of the property, minus any liens the property has. Liens can refer to:

  • the mortgage used to purchase the property
  • any loans that borrow against the property’s equity
  • statutory liens placed against the property, such as a federal tax lien

Equity can also be considered as an interest in the home that the homeowner owns outright. While you own your home fully, it’s not fully yours until you pay the mortgage off in full. Until then, the bank technically has a claim to the home, because it’s being used as collateral to secure your mortgage.

How home equity works

In normal economic circumstances, a home builds equity over time. This is why a mortgage is considered a good debt because having equity increases your net worth. Unlike buying a car, where the vehicle automatically starts to lose value the minute you drive it off the lot, a home generally gains value.

Equity starting out

Three things determine how much equity you have when you first buy a home:

How much is the property worth?

A big part of equity has to do with how much the home is actually worth. When you find a property you like, you make an offer. But that offer can change based on what the property appraiser determines is the value of the home. A property appraisal is key.

How much are you paying for it?

Once the appraisal comes in, the purchase price of the home will be finalized between the buyer and the seller. The purchase price is the first step that will ultimately determine the size of the mortgage that you take out with a lender.

How much are you putting down?

When you purchase the property, you will be required to supply money upfront to cover a down payment. The down payment is equal to a certain percentage of the home’s purchase price.

For a traditional mortgage, you put 20% down, while for an FHA loan* you can put as little at 3.5% down.

To determine the starting equity of a home, you subtract the down payment from the purchase price to determine the loan amount. Then you subtract that amount from the appraised value.

The more money you put down initially, the more equity that you have starting out.

How to build home equity

A home builds equity in two ways:

  1. You pay down the mortgage
  2. The property value increases

As you make monthly payments on the mortgage, you pay off the principal (the actual balance owed on the mortgage). This is usually very gradual – the most common mortgage term is 30 years, so it takes 30 years to pay off what you owe.

At the same time that you’re making payments, the value of the property may also be increasing. Most properties, particularly those that include the land that the property is built on, increase in value over time. You can also do things to increase the value of the property, such as making improvements to it.

So, as the mortgage gets paid down, the value of the property goes up. Thus, your equity grows.

When you sell the home, the equity you have becomes the profit you receive from the sale. The proceeds from the sale are used to pay the remaining balance on the mortgage, then you receive the rest.

Equity example

Let’s say you buy a home with an appraised value of $250,000. You get a traditional fixed-rate mortgage, so you put $50,000 down. This means the mortgage would be for $200,000, so you start out with $50,000 in equity.

Now let’s say that you pay off $15,000 on principal over the next five years. That leaves you with a $185,000 balance on the mortgage.

At the same time, the market value of the home increases to $350,000.  That would mean your equity would be $165,000 ($350,000 – $185,000).

How you can end up with negative equity

As we mentioned above, in normal circumstances the value of a home will increase. However, the circumstances aren’t always normal. In a weak economy, the housing market can “crash.” When this happens, property values can start to fall. You essentially lose equity when this happens.

Statista chart showing value of home equity from 1960-2018

If you purchase the home recently or you’ve borrowed against the value of your home, you can end up owing more than the home is worth. In this case, you have negative equity. This is also known as being upside-down on your mortgage.

The most well-known example of negative equity occurred at the start of the Great Recession. The housing market crashed, and millions of homeowners were upside-down on their mortgages. Many homeowners were forced to sell their homes for a loss and several mortgage lenders folded as a result.

This event should serve as a warning for what can happen when you don’t protect equity and borrow against it carefully. It can put you in an extremely tough financial situation and it can take years to dig yourself out.

Borrowing against equity

Equity is an asset, which means it has value as an investment that you can use to your advantage. Besides what you can earn as profit during the sale, you also have a range of options that allow you to borrow against that equity.

Before you decide to use any of these options, it’s important to understand how borrowing against your home works. You also need to understand the risks, so you can make decisions that are in your best interest.

Q:What is a loan-to-value ratio and why does it matter?

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A: Loan-to-value ratio (LTV) is how mortgage lenders assess the risk of approving a homebuyer or homeowner for a mortgage product. It’s easy to determine:

Current mortgage balance / appraised property value x 100

When you put 20% down on a home, you have a loan-to-value ratio of 80%. When you’re buying a home putting less than 20% down makes the loan a higher risk for the lender. You will face higher interest rates and be expected to pay something known as Private Mortgage Insurance (PMI). You pay this until you achieve 80% LTV.

For someone who already owns their home and wants to borrow against it, you generally must have 80% LTV to borrow against your home. If you use an FHA loan and only put 3.5% down, you won’t be able to borrow against the home until you hit the 80% LTV threshold.

Ways to borrow against equity

Once you pass the 80% LTV threshold, you can borrow against your equity. However, you can’t borrow up to the limit. Most lenders only allow you to borrow up to 80-85% of the available equity that you have.

There are several types of products that allow you to tap your equity for funds.

Home equity loans

A home equity loan is also known as a second mortgage because it’s a second lien placed on the property after the purchase mortgage.

You can borrow up to 80-85% of the available equity you have and receive the funds in a single lump-sum. You pay the money back in installment payments over a term of 5-30 years. The interest rate is fixed and locked in at the time you borrow.

Home Equity Lines of Credit (HELOCs)

A Home Equity Line of Credit (HELOC) is an open credit line that you can borrow against as needed. You receive a credit limit of up to 80-85% of the equity you have available in your home.

HELOCs have a 10-year “draw” period, where you can withdraw funds at any time over ten years. During this time, you only make payments on the interest accrued on your balance. HELOCs can have a fixed or variable interest rate.

After 10 years, you can no longer withdraw funds and must start repaying the principal balance owed. As a result, the payments can increase significantly at the 10-year mark.

Cash-out refinance

Another way to borrow against your home is with a cash-out refinance. In this case, you’re not taking out an additional lien against your property; you’re replacing the existing one.

You take out a new mortgage based on your home’s current appraised value. The first mortgage is paid off. Then you receive most of the difference.

You can generally borrow up to 80-90% of the home’s available equity. This leaves you with an LTV of 80-90% on the new loan.

Reasons to use your equity

Home equity funds can really be used for anything you want to use them for, but not all uses are good.

Home improvement

One of the best uses of home equity is to fund large home improvement projects. This increases the property value; thus, it helps you build your equity back up.

Investment

Another smart use of equity is to use it for investment seed money. Starting a college education fund for your children or giving your retirement savings a big boost.

Even for basic savings investments, if the rate of return on the investment is higher than the interest rate on the home equity loan or HELOC, then it may make sense to use equity to grow your net worth.

Debt consolidation

Another common use of equity is to consolidate and pay off existing debt. You can use the funds you receive from a home equity loan, cash-out refinance, or HELOC to pay off credit card debt, medical bills, back taxes, child support arrears, and really any other debt you want to eliminate.

This can be beneficial, given that financing that uses your home as collateral tends to have much lower interest rates than other forms of borrowing. You can consolidate your debts into one monthly payment and save money as you get out of debt.

However, this is not without its risks. Converting unsecured debt to secured using a home equity lending product increases your financial risk.

If you don’t pay a credit card, you can end up with a collections account. The collector may sue you in civil court, which could lead to issues like wage garnishment. But that’s the worst that can happen.

If you borrow against home equity and fall behind with the payments, you could be at risk of foreclosure. You could lose your most valuable investment and the roof over your head.

Always consult with a financial expert before you borrow against your equity. You want to make sure it’s the best solution and that it won’t get you into trouble down the road.

Talk to a certified expert to discuss options for debt consolidation before you borrow against your equity.

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Pros and cons of tapping home equity

Borrowing against your home has its advantages, but it also has its risks. Here’s how it stacks up versus unsecured borrowing options, such as personal loans.

Pros Cons
You can qualify for a lower interest rate, even with a weaker credit score. Much higher financial risk. Since the is secured using your home as collateral, you could be at risk of foreclosure if you fall behind on the payments.
You may be able to borrow more money than you can with unsecured credit, which generally caps out at $50,000. The upfront cost of borrowing is higher. You may need to pay for property appraisal and can face a fresh round of closing costs.
Mortgage interest may be tax-deductible, meaning borrowing against equity can be beneficial for tax planning. Terms are generally longer than unsecured borrowing options, which typically have maximum terms of 5 years as opposed to up to 30 years.

FAQ

Q:Can I use a home equity loan or line of credit to buy another house?

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A: Yes. You can use funds from a home equity loan or HELOC to buy a second home, vacation home, or investment property. Leveraging home equity is a popular way to fund investment and rental property purchases.

Q:Do you need a property appraisal for a home equity loan or line of credit?

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A: The property must be appraised to some extent to determine the value of the property.

However, a full property appraisal is often not required to borrow against home equity. Many lenders can use tools like automated valuation models (AVMs) to determine the current market value of the property. This is true for home equity loans, HELOCs, and even cash-out refinancing.

However, in some cases, a full appraisal may be required, which will make upfront borrowing costs higher. A full appraisal generally costs between $300-$400.

Q:Does the VA offer home equity loans or lines of credit?

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A: No. The VA only funds first-lien mortgages – the primary lien or mortgage against the property. This means you cannot go through the VA to get a home equity loan or HELOC.

However, a cash-out refinance is a first-lien mortgage, since it pays and replaces the existing mortgage. This lending option is available through the VA.

Q:How long does it take to get a home equity loan or HELOC?

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A: On average, it takes 14-28 days to get a home equity loan or HELOC. Cash-out refinancing takes 30-45 days on average.

Q:How much equity can I borrow from my home?

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A: This varies based on the lending product and the lender. With second-lien products such as home equity loans and HELOCs, you can generally only borrow up to 80-85% of the equity you have available. Some lenders will allow you to use up to 90% of the available equity on a cash-out refinance.

Q:Is it better to refinance or get a home equity loan?

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A: It depends on your situation and economic conditions. Second-lien products such as home equity loans and HELOCs have higher interest rates than a first mortgage if you use a cash-out refinance. On the other hand, they tend to have lower closing costs, so the upfront cost burden is lower.

You also need to consider factors like the amount of equity that you have available, what you plan to use the funds to do, and how long you plan to stay in the home.

Economic factors can also come into play. For instance, currently many lenders are limiting home equity loans and HELOCs because second-lien products can be risky for them if we face another housing market crash.

Q:What is better a home equity loan or line of credit?

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A: This depends on your needs, goals, and financial habits. There are three major differences between the two products:

  • One-time cash injection versus open credit line
  • Fixed versus variable interest rate
  • Installment versus revolving payments

Home equity loans can be easier to make because they are installment credit. You have a fixed monthly payment that may be easier to manage. You also enjoy a fixed interest rate.

HELOCs have revolving payments. You pay interest-only during the 10-year draw period. Then your payments balloon because you must pay principal plus interest. The interest rate is also variable. So, HELOCs can be harder to manage.

The better choice also depends on how you plan to use the funds. If you know the exact amount that you’ll need, then a home equity loan makes sense. If you have concerns that you may need more funds down the road, then a HELOC may make more sense.

Q:What is needed for a home equity loan or line of credit?

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A: First, you must have equity available. You need a loan-to-value ratio of at least 80% on your home before you can even consider borrowing against equity.

You will also need to meet the lender’s requirements for credit score and debt-to-income ratio. Most lenders require at least 680 to qualify for a home equity loan or HELOC.[2] Your debt-to-income ratio generally needs to be less than 42-45% with the new loan payments factored in.

Then you need everything that’s required to apply for the loan or line of credit. You may need a full property appraisal, as well as money for closing costs which usually average 2-5% of the amount borrowed. You will also need documentation to verify your identity, income, and address.

*A FHA loan is a mortgage that is backed by the Federal Housing Administration (FHA). These loans are designed for low-to-moderate income homebuyers who may have trouble qualifying for a traditional mortgage. These loans allow a homebuyer to qualify for as little as 3.5% down.

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Article last modified on June 9, 2020. Published by Debt.com, LLC