There are many perks to home ownership. You can paint your walls whatever color you want. You can have a cat (or three). And you can also establish equity — that is, gain full ownership of your home bit by bit as you pay down your mortgage. Over time, that equity can improve your net worth, and you can even borrow against it when you need cash to fund home improvements or consolidate debt.
US home prices are up 42% since the beginning of the pandemic, according to a report from data analytics company Black Knight. That means millions of homeowners now have thousands more in equity than they did just a few years ago. If you’re one of them, you may have the opportunity to tap into your home equity to help accomplish your personal or financial goals. But before you can do that, you first need to understand what home equity is, how it works, and how you can use it to your advantage. Here’s what you need to know.
Home Equity Defined
Home equity is the current value of your home minus what you owe on your existing mortgage loan. For example, if your home is worth $300,000 and you owe $150,000 on your mortgage, you have $150,000 in equity.
How Does Home Equity Work?
How much equity you have in your home is calculated as the difference between your home’s current market value and your mortgage balance. Over time, your equity amount can fluctuate for the following reasons:
Home values change
As homeowners across the country have experienced, home values can increase — sometimes dramatically. If your house’s market value goes up, you can gain a significant amount of equity even though your mortgage balance hasn’t changed.
For example, let’s say your home was worth $300,000, and you owed $150,000 on the home loan, giving you $150,000 in equity. Thanks to skyrocketing house prices, your home is now worth $350,000. Even if you made no progress against the mortgage balance, your equity would increase to $200,000.
However, you should know that home equity can also decline if your home’s value drops at a faster rate than you pay down your mortgage. If you owe more on your mortgage than what your home is worth, you have negative equity, also known as being underwater on your loan.
Decreased Mortgage Balance
Your equity will increase naturally as you pay down your mortgage balance with each monthly payment. But some people are laser-focused on paying off their mortgages early. If you make extra payments, increase your monthly payments to more than the minimum, or use windfalls to make lump sum payments against the principal, you can decrease the balance and increase your equity.
For example, let’s say you own a $300,000 home and currently owe $150,000. You received an unexpected windfall of $5,000. By applying that full amount to your mortgage, you reduce the balance by $5,000, and you now owe just $145,000. As a result of the lower balance, your equity increases to $155,000.
Increasing your home equity by paying down your loan balance has another perk: once you hit 20% equity, you can request the cancellation of private mortgage insurance (PMI), an added monthly cost to your lender charges on conventional loans when you put less than 20 % down.
How Can You Use Your Home’s Equity?
You can borrow against your home if you’ve built enough equity, says Madison Block, senior marketing communications associate with the non-profit credit counseling agency American Consumer Credit Counseling.
“Home equity can be used as collateral to turn into cash through a home equity loan or home equity line of credit (HELOC),” Block says. “They’re often used for home improvements, major purchases or expenses, and debt consolidation.”
When determining how to use your home’s equity, consider your loan-to-value ratio (LTV). Your LTV is a measure lenders use to compare the amount of mortgage debt you have with the appraised value of your property.
To calculate your LTV, divide your loan balance by the home’s value. For example, if you owe $150,000 on a $300,000 home, divide $150,000 by $300,000. The result — 0.50 or 50% — is your LTV.
In general, most lenders allow you to borrow around 80% to 85% of the equity in your home. To figure out how much you can borrow, multiply the lender’s maximum loan-to-value ratio by the value of your home, then subtract the balance on your mortgage. For example, if you have a $300,000 home and owe $150,000 on your mortgage, here’s how you would calculate your maximum loan amount when borrowing against your home equity:
- $300,000 (current value of home) x 0.80 (lender LTV limit) = $240,000 (maximum equity available to borrow, not including your primary mortgage)
- $240,000 (maximum equity available) – $150,000 (current mortgage balance)= $90,000 (the maximum you can borrow)
Best Options to Borrow Against Your Home’s Equity
If you have a major expense coming up, you can tap into your home’s equity to cover the cost. There are three main ways to borrow against your home equity:
Home Equity Line of Credit (HELOC)
A HELOC is a revolving line of credit, meaning you can use it again and again during the HELOC’s draw period. A bank or credit union will approve you for a certain credit limit based on your available equity, and you can use up to that amount. HELOCs usually have variable interest rates, but you pay interest on only the amount you use, not the entire credit line.
Home Equity Loan
A home equity loan is an installation loan that gives you one lump sum of cash upfront. Like a HELOC, a home equity loan is secured by your home. Unlike a HELOC, a home equity loan has a fixed interest rate and fixed monthly payments. Because they are collateralized, home equity loans tend to have lower interest rates than other forms of credit, such as personal loans or credit cards.
Home equity loans and HELOCs are second mortgages, meaning they’re separate from your primary mortgage. Taking out a home equity loan doesn’t affect your current mortgage’s rate or repayment period.
Cash out refinance
Unlike home equity loans and HELOCs, cash-out refinancing is a way to replace your existing mortgage with an entirely new loan.
With a cash-out refinance, you take out a new mortgage for more than you owe on the current one. After paying off the existing mortgage, you receive the difference as a lump sum of cash.
The new loan will have different terms than your old one, so you’ll have a new repayment period and interest rate.
If you currently have a low mortgage rate, keep in mind that a cash-out refinance loan will likely have a significantly higher rate. For example, in January 2021, rates were as low as 2.93% for a 30-year, fixed-rate mortgage. As of June 2022, the average rate is 5.78%. If you bought your home or refinanced when rates were low, it might not be worth it to get a cash-out refinance at a higher rate now.
Cash-out refinancing also typically comes with upfront closing costs. Home equity loans and HELOCs sometimes also have closing costs, but they’re typically lower and are more likely to be waived by lenders.
How to Build More Equity in Your Home
To build more equity in your home, use these tips:
Put Down a Larger Down Payment
A large down payment allows you to establish equity sooner, according to Todd Christensen, education manager with Debt Reduction Services, a non-profit credit counseling agency.
“The larger your down payment, the greater your home equity from the moment you take ownership of your home,” says Christensen.
Plus, you can avoid private mortgage insurance (PMI) if you put down at least 20%, saving you some extra money.
Make Extra Mortgage Payments
Paying more than the minimum required allows you to chip away at the mortgage principal faster. Over time, extra payments — even as little as $50 to $100 per month — can help you establish more equity.
“Every payment you make toward your home’s principal balance generally increases your home equity,” says Christensen. “Making extra principal payments lowers your mortgage balance and therefore increases your equity.”
An easy way to build equity is to switch to a biweekly payment schedule. You’ll end up making an extra mortgage payment every year, increasing your equity and reducing interest charges.
You can make regular extra payments every month, or use sudden windfalls to make lump-sum payments to reduce the mortgage principal and boost your equity. If you currently pay PMI but qualify for removing it — which requires building up 20% equity in your home — you can also put the monthly savings from getting rid of PMI toward adding a little extra to your monthly mortgage payment.
Complete Remodeling Projects
There are some home improvements that can increase your home’s value, giving you more equity.
- Refining floors: Refinishing hardwood floors costs $3,400, on average. But in the National Association of Realtors’ 2022 Remodeling Impact Report, realtors estimated that sellers would recoup $5,000 — an 147% increase.
- adding a bathroom or bedroom: The National Association of Home Builders reported that 78% of homebuyers wanted at least three bedrooms in a new house, and 84% wanted two or more bathrooms. If your home doesn’t meet those criteria, adding a bedroom or converting a half-bath into a full bath can increase the home’s value.
- Adding an accessory dwelling unit: Homes with an accessory dwelling unit, also known as an in-law suite, are priced approximately 35% higher than homes without one, according to Porch, a site that connects homeowners with home improvement professionals.
As an added bonus, home equity loans or HELOCs used for home improvements can have tax benefits. “The interest paid is usually tax-deductible,” says Block. You just need to make sure you meet certain other requirements.
Wait for property values to rise
When your home’s market value increases due to market conditions, you gain home equity without having to do anything. However, this may take time. While there have been massive spikes in home values over the past two years — average home prices are up 42% since the beginning of the pandemic — home values usually appreciate at a more modest rate. The average yearly increase in home values from 1999 to 2019 was 3.9%, according to data from Black Knight’s home price index provided by a Black Knight representative.
Keep in mind that as property values rise, your property taxes may also increase, which could increase the cost of homeownership.
Is It Safe to Borrow Against the Equity of Your Home?
While borrowing against your home equity can be tempting, there are some risks:
- You risk foreclosure: “A major risk of borrowing against equity, such as with a HELOC, is that you could lose your home if you default on the loan because your home is the collateral,” cautions Block. If you don’t make your payments, the lender can begin foreclosure proceedings against your home.
- You increase mortgage debt: When you borrow against your home equity, you’re adding to your overall mortgage debt. It can take more time to pay off your mortgage, and that problem can make it difficult to retire or save for other financial goals.
- You could be tempted to overspend: Having access to a large sum of cash or a line of credit can tempt you into overspending on non-essentials and cause you to rack up unnecessary debt. “I highly discourage the use of home equity for anything that does not either increase your net worth or increase your earnings,” says Christensen. “Borrowing against your home equity is still debt, and debt will always involve risk and almost always involve interest.”
To minimize those risks, only borrow what you need, and be sure to have a strategy in place for repaying the borrowed funds. For non-necessary expenses, such as a vacation or wedding, consider budgeting and setting aside money each month in a savings account rather than borrowing money.