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What Is Home Equity?
The difference between your mortgage balance and the current market value of your house is known as home equity, and it represents the part of your house that you actually own. Your equity rises as you pay off your loan and the value of your house increases.
Simply said, home equity is determined by deducting the present market value of your house from any outstanding debts or liens, such as your mortgage.
This equity is an effective financial instrument. It can be used to pay for significant expenses like paying for college tuition or consolidating high-interest debt. You can make better financial decisions if you know how home equity functions, how to calculate it, and how to use it.
Key Takeaways
Home equity represents the difference between your property’s current market value and any outstanding debts like your mortgage.
You can tap into your home equity to secure financing, such as a home equity loan or a home equity line of credit (HELOC).
Making a down payment of 20% or more on your home gives you instant equity from day one.
Your home equity will rise or fall depending on changes in the real estate market value of your property.
How Home Equity Works
In theory, your lender has a financial stake in the house you purchased, whether you paid it off in full or in part, if you did so with a mortgage loan. Home equity is the portion of your home’s value that you actually own.
As soon as you make a down payment, you begin to accumulate equity. After that, equity keeps rising gradually with each mortgage payment you make. A portion of each monthly payment is used to pay interest, and another part is used to lower the principal balance, or the total amount you still owe on the loan.
Home equity can also increase if the market value of your home rises over time. However, it’s important to note that if your property’s value drops, your equity could decrease. Additionally, if you take out a second mortgage using your current equity as collateral, it can reduce the total equity you hold.
How to Figure Out Your Home Equity
In simple terms, home equity is the difference between your home’s current market value and the remaining balance on your mortgage loan.
To estimate your home equity, begin by researching the sale prices of similar homes in your neighborhood to get an idea of your property’s current value. Let’s assume your home is valued at $350,000, and you still owe $150,000 on your mortgage. Using those numbers, here’s how to calculate your equity:
Home Equity = Current Home Value – Mortgage Balance
Home Equity = $350,000 – $150,000
Home Equity = $200,000
That $200,000 represents the amount of your home that you fully own. It’s a powerful financial asset that can grow over time and even be tapped into when needed—just be mindful of the risks.
Example of Home Equity
When you purchase a home for $300,000 and put down 20%, you’re investing $60,000 upfront and financing the remaining $240,000 through a mortgage. That initial $60,000 becomes your starting home equity.
If the property’s market value stays the same over the next two years, and you pay off $15,000 of the mortgage principal during that time, your home equity would grow to $75,000.
Now, if the home’s market value also rises by $100,000 in those two years, your total equity would jump to $175,000.
Key Insight
Home equity adds to your net worth and is considered a valuable asset. However, it’s not cash-ready or easily accessible, so it’s not classified as a liquid asset.
How to Borrow Against Home Equity
When compared to credit cards or personal loans, borrowing against the equity in your home typically has a lower interest rate. This is because the loan is less risky for lenders because it is backed by the equity in your property. Your home equity may be a dependable source of funding if you’re in need of money. Additionally, the interest may be tax deductible if you use those funds for home improvements.
IRS Publication 936 (2021) states that interest paid on loans linked to your home equity may be deductible from taxes if the money is used to improve the property.
Your home equity isn’t as liquid as stocks or other assets. A property appraisal that reflects the current market value is necessary. This appraisal does not, however, ensure that you will sell the house for that amount.
Nonetheless, homeowners can obtain low-interest financing in a number of clever ways by using their equity. HELOCs (Home Equity Lines of Credit), cash-out refinances, home equity loans, and fixed-rate HELOCs are popular choices.
Home Equity Loan
Also known as a second mortgage, a home equity loan lets you borrow a lump sum at a fixed interest rate for a fixed term. These loans are often used for big expenses like major home repairs, renovations, or even paying for college tuition.
Home Equity Line of Credit (HELOC)
A HELOC is a flexible, revolving credit line with a variable interest rate. It allows you to borrow as needed, up to a preset limit. Think of it like a credit card tied to your home’s equity—borrow, repay, and borrow again as necessary.
Fixed-Rate HELOC
Some lenders offer the option to convert part or all of your HELOC into a fixed-rate loan. This is known as a fixed-rate HELOC. Once converted, you’ll repay the amount over a defined period. Be sure to review your lender’s terms, as the rules around fixed-rate HELOCs can vary.
Cash-Out Refinance
Cash-out refinancing involves replacing your current mortgage with a new one that’s larger than what you owe. The difference between the two amounts is paid out to you in cash. You can use this money however you like—there are no restrictions. And since this is considered debt, not income, the IRS does not tax it.
Important Notice on Fair Lending
Discrimination in mortgage lending is against the law. If you suspect you’ve been denied or treated unfairly due to your race, gender, religion, age, disability, marital status, public assistance use, or national origin, you have the right to take action. You can file a complaint with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
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How to Use Home Equity
How to Make the Most of Your Home Equity to Help Your Finances
Making use of your home equity may present chances to improve your financial circumstances.
Eliminate PMI Early: You can ask to have your private mortgage insurance (PMI) cancelled once your equity reaches 20%. At 22%, the majority of lenders automatically remove PMI, but you can save money by taking action sooner.
Consolidate High-Interest Debt: To settle high-interest credit card debt, apply for a home equity loan or credit line. You can lower your monthly payments with these loans because they frequently have significantly lower interest rates.
Cover Major Costs: Instead of using high-interest credit cards, use home equity funds to handle big expenses—like college tuition or a wedding. This allows you to borrow at a lower rate while avoiding expensive short-term debt.
How to Increase Your Home Equity
It’s time to concentrate on increasing your home equity once you realize how valuable it can be. Here’s where to begin:
- When purchasing a home, make the largest down payment possible to gain immediate equity.
- Select the appropriate mortgage. Steer clear of interest-only loans that postpone principal payments.
- Make timely mortgage payments and make an effort to pay more than the minimum amount due.
- Remain in your house and take advantage of the increasing value of your property. You may accumulate more equity the longer you stay there.
- Make improvements that raise the value of your house. Do your homework first because some enhancements increase value more than others.
Pros and Cons of Borrowing on Home Equity
Pros
Lower requirements
Lower interest rates
Tax deductible interest
Added debt
Potential fees
Restricted use
Pros Explained
Easier Approval Process:
When you borrow against your home’s equity, lenders often have more relaxed approval criteria. This is because your home serves as collateral, giving the lender more security. If you fail to repay the loan, they can recover the money by selling your property, which reduces their risk.
Lower Interest Rates:
Home equity loans generally come with lower interest rates compared to unsecured personal loans or credit cards. Over time, this can lead to significant savings in interest payments.
Tax Benefits:
If you use the home equity loan for qualifying home improvements, the interest you pay may be tax-deductible. This can help reduce your overall tax liability, offering another layer of savings.
Cons Explained
Increased Debt Load:
Taking out a loan means taking on more debt. This raises your total monthly obligations and can tighten your monthly budget. It also impacts your credit score, which could affect your ability to secure future loans or result in higher interest rates.
Extra Fees:
Home equity products may come with closing costs, appraisal fees, or other charges. These added expenses increase the total cost of borrowing beyond just the interest rate.
Limited Spending Options:
Some home equity loans or lines of credit come with restrictions on how the money can be used. Often, funds must be spent on home-related projects, like remodeling or repairs, limiting your flexibility.
FAQs
1. Do I need a tax return to qualify for a HELOC?
While it’s technically possible to get a HELOC or home equity loan without submitting your tax return or proof of income, such “low- or no‑documentation” loans tend to be more expensive and harder to qualify for. Many lenders avoid them due to increased risk.
2. How do I calculate how much home equity I have?
Home equity is calculated by subtracting the outstanding balance on your mortgage (and any other liens) from your home’s current market value.
(Example: a $250,000 house minus $150,000 mortgage = $100,000 in equity).
3. What do I need to get a HELOC or a home equity loan?
Lenders typically require:
At least 20% equity in your home,
A credit score of 600 or higher,
A stable income record over the past 2 years.
Borrowers with less equity or income generally pay higher interest rates.
4. Can I use a HELOC for a down payment?
Yes—but it’s risky. You’d be borrowing against your current home to fund another property’s down payment. Make sure you have enough monthly cash flow to cover mortgages on both properties plus the HELOC payments.
5. How much money can I get from a home equity loan?
Typically, you can borrow up to 85% of your home equity. Remember that closing or setup costs may reduce the actual amount you receive.
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