What Is a Home Equity and How Does It Work?

Your home is one of the most important investments you will ever make in your life. It’s also a great source of potential financing for a wide variety of purposes. 

Home equity is the difference between the current market value of your home and the amount you still owe on your mortgage. Read along to find out what exactly home equity is and how to use it to finance a wide variety of projects!

Let’s go!

What is a Home Equity?

The value of a homeowner’s interest in their house is known as home equity. In simpler terms, it is the present market value of the actual property. The equity in a property—or its worth—varies over time as new mortgage payments are made, and market forces influence the property’s current value.

If a property is bought using a mortgage loan, the lender has an interest in the home until the debt is paid off. Home equity is the portion of a home’s current value that the owner possesses at any given time.

The down payment you make when you buy a house is the first form of house equity you obtain. Subsequently, more equity is gained through your mortgage payments since a portion of that money will be applied to pay off the outstanding principal remaining.

home-equity

How do you Build Home Equity?

There are a few methods to improve your property equity. Here are some of the most common strategies that homeowners use:

Pay your loans on time: This one is pretty straightforward. Making your mortgage payments on time will help improve your credit score and, in turn, increase the equity in your home.

When you reduce your loan balances, the equity in your property increases. The majority of house loans are amortizing loans with equal monthly payments that go to both interest and principal. As the money that goes into the principal repayment gradually increases, building your equity will get faster every year.

Stay in your home for more than 5 years: If you stay in your home long enough, the amount of equity you’ve built up will exceed the costs associated with selling and buying a new property.

Accelerated mortgage payments: This is a term that refers to increasing the amount of money paid by borrowers to finance their homes.

Homeowners are most likely to make monthly mortgage payments or a total of 12 payments per year. If you divide your monthly payment into two equivalent payments, you’ll end up making 26 payments each year. This approach will eliminate a significant amount of interest, as well as help you pay off your mortgage and build property equity faster.

Make home improvements: Adding value to your home through renovations or repairs can help you build equity more quickly. However, it’s important to remember that some improvements will increase your home value more than others. 

Rise of property values: Property values generally rise over time. Appreciation is a term used to describe this phenomenon. There’s no way to know how long it will take for your home’s value to appreciate because its value depends on a variety of factors, including your location and the economy. 

Putting down a larger down payment: A larger down payment will decrease the amount you need to borrow and, as a result, increase the equity in your home.

For instance, if you chose to put down 20% instead of 10% equity on a house, you would have more equity. Since lenders usually demand that you have 20% equity in your property, doing so may allow you to access it faster.

Refinance your mortgage: If interest rates have gone down since you took out your loan, refinancing could save you money and help you build equity faster.

A home equity loan is a type of loan in which the borrower uses the equity of their house as collateral. A home equity loan is often used to finance major expenses such as home repairs, medical bills, or college education.

How to Use Home Equity?

Once you have built up equity in your home, you may be able to use it for a variety of purposes, including:

Sell your property: This is the most straightforward way of using your home equity. Selling your property will give you a lump sum of cash that you can use for any purpose.

Borrowing against home equity: Another option is to borrow against the equity in your home. This can be done in a few different ways, such as taking out a home equity loan or using a home equity line of credit (HELOC).

Renovations: A popular use of home equity is to finance renovations. This can be a cost-effective way to make improvements to your property because you’re using the money you’ve already put into your home.

Retirement: You can also use your home equity to help finance your retirement. This can be done by taking out a reverse mortgage, which allows you to borrow against the equity in your home and receive payments from the lender.

home-equity

Buy a second property: Another option is using your equity to buy another house. This can be done by taking out a mortgage on the new property or using the proceeds from the sale of your current property.

Pay for your tuition: Another option is to use your home equity to pay for your college education. This can be done by taking out a home equity loan or line of credit.

There are a number of different ways you can use equity in your home. It’s important to consider how you might want to access it before you start building up equity.

You might be interested: Asset Management

Pros and Cons of Home Equity

There are a number of pros and cons to using home equity, so it’s important to weigh them carefully before you make a decision.

Benefits of Home Equity

Some of the benefits of using home equity include:

Lower interest rates: Your home is the security for your home equity loan or line of credit. Unsecured debt, such as credit cards or personal loans, has higher interest rates than secured debt. If you need to reduce high-interest debt, this may save you money on interest payments while also increasing your income.

Tax benefits: You may be able to deduct the interest you pay on a home equity loan or line of credit from your taxable income. This can save you money, especially if you’re in a higher tax bracket.

No usage restrictions: You can use a home equity loan or line of credit for any purpose, including debt consolidation, home repairs, or tuition.

Flexible repayment options: Home equity loans and lines of credit typically have shorter terms than mortgages and offer more flexible repayment options. This can be helpful if you need to reduce your monthly payments.

Drawbacks of Home Equity

You can also expect a few disadvantages of using home equity:

Risk of losing your home: If you can’t make your payments, you could lose your home. This is why it’s important to only borrow what you can afford to pay back.

Borrowing costs: Home equity loans and lines of credit usually have closing costs, such as appraisal fees and origination points. These can add to the cost of borrowing.

Less available funds: Since your home is used as collateral, you may not be able to borrow as much money as you would with an unsecured loan.

Property value decrease: If your property value decreases, you may owe more than your home is worth. This is called being “underwater” on your mortgage.

These are just a few of the pros and cons of using home equity. It’s important to weigh the benefits and drawbacks carefully before you decide if this is the right option for you.

Final Thoughts

Home equity can be a valuable tool if you need to access money for a specific purpose. It’s important to weigh the pros and cons carefully before deciding if this is the right option for you. You can use home equity in a number of different ways, including financing renovations, retirement, or college education.

Learn more: How to Start a REIT?

FAQ

How do equity loans work?

A home equity loan is a type of second mortgage. Your first mortgage is the one you used to purchase your home, but you can place additional loans against the property as well.

How is home equity calculated?

The amount of equity in your house is determined by the current value of your property, any outstanding debt secured by it, and other liabilities.

ABOUT AUTHOR

Despite her formal background in linguistics, Maja has always been fascinated by the world of finance. She has spent years and years analyzing the market, including trades, investments, pitfalls to avoid as well as the stock exchange. As of recent, she has been studying some non-mainstream stocks in Canada. When I’m not immersed in numbers, I like to spend time with my dog and plan my next trip.

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