The term “home equity” gets thrown around quite often, but not everyone knows exactly what it means. The simple explanation is that home equity is the value of your home, minus the amount you still owe on the property.
One way to think of it is this: home equity is the portion of your home that you actually own. If you took out a loan to purchase your home, your lender also owns it. That is, until you pay off the remaining balance on your mortgage.
As an example, let’s say you purchased a property for $200,000, and you made a down payment of $40,000. That would mean that you borrowed $160,000 to purchase the home. So, at the beginning, if your home is worth $200,000, and you owe $160,000, you have $40,000 worth of equity in your home. Now let’s fast forward 5 years down the road. Through your regular monthly mortgage payments, you’ve reduced your loan balance and you currently owe $146,000 on your home. In addition, the value of your home has increased and is now worth $215,000. So, your home equity would now equal $69,000 (a home value of $215,000, minus a $146,000 mortgage balance).
The amount of equity you have in your home typically increases as you continue to pay down your mortgage, and your home’s equity can also rise if the value of the property increases. The ability to build equity is one of the major benefits of owning a home. When you’re paying your mortgage bill every month, it might not feel like you’re putting money into an investment account, but in a way that’s exactly what you’re doing. As your home equity grows, you end up with a larger investment.
And believe it or not, you don’t necessarily have to wait until selling your home to tap into that investment. If you have enough existing equity in your home, you could potentially use it to take out a loan or line of credit. Many homeowners tap into their home equity
to help pay for things like home improvements, vacations, or education expenses. Other homeowners use their home equity to pay off high-interest credit cards, so they can consolidate their debt at a lower rate.
So what exactly is the difference between a home equity loan, and a home equity line of credit? With a home equity loan
, you borrow a lump sum of money, and get access to it all at once. You’ll then typically pay it back with a flat monthly payment over a several-year period, usually at a fixed interest rate.
A home equity line of credit
(commonly referred to as a HELOC), works more like a credit card than a traditional loan. You’re given a “line of credit”, which is the maximum amount that you can borrow. You then tap into this credit line to access funds when you need them over a set period of time. During this set period, commonly referred to as a “draw period”, you can withdraw money when needed, and you’ll typically be responsible for making modest repayments of the funds borrowed. Once the draw period expires, you enter the “repayment period”, where more substantial repayments will usually need to be made. HELOCs usually have a variable interest rate, which means that the interest rate can fluctuate over time.
When applying for a home equity loan or line of credit, the fair market value of your home will need to be evaluated to determine the true amount of equity you have in your home. From there, if you qualify for the loan, your lender will determine a maximum amount that you can borrow. Lenders will typically limit the amount of a home equity loan or line of credit to 80% or less of your home’s value, which is also known as the “loan to value”, or LTV, ratio.
Other restrictions and requirements, such as a minimum credit score, can apply as well, and may vary by lender. If you’re interested in taking out a home equity loan or line of credit, it’s best to start the process by speaking with a qualified mortgage professional
It’s also important to remember that when you take out a home equity loan or line of credit, you’re using your home as collateral. So, if you end up defaulting on these types of loans (in other words, not paying back the money you owe), you could risk losing your home as a result. And, it’s a good idea to keep in mind that your home equity is not guaranteed to increase over time. If the value of your home decreases, for whatever reason, the amount of equity you have in it will decline as well. For these reasons, it’s always a good idea to consult with a financial manager, tax advisor, or other trusted professional before making any major financial decisions.