Home Equity: What Is It And How Can You Use It?
Updated May 30, 2024 at 12:30 pm
Home equity represents the portion of your home that you own. You establish home equity with the down payment on your home loan, then it builds steadily as you make monthly mortgage payments and watch the home’s value climb. You can tap that equity when you need to borrow money, so it’s an important tool to know about. Here’s a closer look at how home equity works and how you can use it.
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Vault’s Viewpoint on Home Equity
- Home equity is the difference between your home’s current market value and the balance on your first mortgage.
- A home equity loan and home equity line of credit (HELOC) are two of the products that allow you to borrow money using your home as collateral.
- You can use funds from a home equity loan or HELOC for just about anything—but it’s typically a good idea to use the money to get financially ahead.
What Is Home Equity and How Does It Work?
Home equity is a value that reflects the difference between the price your home could sell for and the balance you have on any outstanding mortgages. For example, if your home is worth $400,000 and you have a mortgage balance of $300,000, then you have $100,000 in equity.
A portion of your monthly mortgage payments goes toward paying down your principal, so you build equity steadily over time. You also build equity as your home’s value rises naturally. The national average for home appreciation is 3% per year, though homeowners have gained equity faster over the past few years. Between January 2021 and June 2022, homeowners in the U.S. gained an average of $60,000 in home equity, thanks to rising home prices.
5 Common Ways To Use Your Home Equity
While you own the equity you’ve built, you typically won’t be able to use your asset until you sell the home. But another way to convert your home equity into cash is by taking out a home equity loan, HELOC or a cash-out refinance.
These options provide flexibility because lenders usually won’t restrict how you spend the money. But the most popular ways to use home equity either involve getting financially ahead or adding value to your home. Here are some common options:
Debt Consolidation
Using a home equity loan or HELOC to pay off high-interest debt can make a big difference in your day-to-day life. Many homeowners use this strategy to wipe out balances on credit cards, personal loans, medical bills and more. If the interest rate on the home equity loan is lower than the rates on your debts, then you come out ahead because you save money on interest and potentially lower your monthly bills. Plus, it’s generally easier to have just one payment to track each month.
But it’s important to avoid charging more to your credit cards or taking out new loans as you pay down the home equity loan. Otherwise, you’ll be back in the same spot you were in before taking out the loan.
It’s also important to understand that using home equity to pay off credit cards and personal loans means you’re turning unsecured debts into secured debt. Your home is on the line, so be sure you can make the payments each month.
Home Improvements
One of the most common ways to use funds from a home equity loan is to pay for home improvements. Projects like bathroom renovations, basement finishes and a new roof can increase the resale value of your home, improve your living experience or even repair damage to your home.
You typically won’t get a 100% return on your investment, but you’re still replenishing some of the home value that you removed when you took out the home equity loan. Plus, the interest you pay on a home equity loan or HELOC is tax-deductible when you use the funds for home improvements.
Starting a Business
Business owners who want to take out a business loan may be disheartened by the strict requirements, which usually include at least six months’ time in business. This requirement can make it difficult to borrow money for important start-up costs like inventory and office space. But it’s relatively easier to qualify for a home equity loan or HELOC, and they offer high borrowing limits, long repayment terms and potentially low interest rates. These features make home equity products a good choice for funding a newer business.
However, you’ll need to weigh the benefits against the downsides. About 23% of businesses fail after the first year, according to data from the Bureau of Labor Statistics. If your business isn’t profitable and you fall behind on loan payments, you may lose your home. Plus, using home equity to fund your business won’t help you build business credit.
Funding Investments
It’s also possible to use funds from a HELOC or home equity loan to invest in real estate, the stock market or another high-value asset. Investment properties, for example, typically require you to put 15% to 20% down depending on your credit score. On a $400,000 property, you’d need about $60,000 to $80,000 plus closing costs. The funds could come from using a home equity loan or HELOC against your primary home. The rental income would ideally cover the cost of repaying the loan and the mortgage on the investment property.
While it’s impossible to predict the return on your investment, you should try to invest in assets where the average rate of return is higher than the interest rate on your HELOC or home equity loan.
Setting Aside for Emergencies
Financial experts generally recommend keeping three to six months’ worth of expenses in an emergency fund. This money can keep you financially afloat in an emergency like a job loss or during a medical issue. If you don’t have an emergency fund, a HELOC could be a safety net while you save up.
Ways To Tap Your Home Equity
There are three main ways to leverage your home equity:
Home Equity Loan
A home equity loan is a type of second mortgage that allows you to borrow money using your home as collateral. Lenders often allow you to borrow up to 85% or 90% of your home’s value, minus the balance on your first mortgage. You usually receive the funds as a lump sum and make installment payments over a stretch of five to 30 years. These typically come with a fixed interest rate and predictable payments.
Home Equity Line of Credit (HELOC)
A home equity line of credit, or HELOC, is another type of second mortgage that shares similarities to the home equity loan. You can borrow around 85% to 90% of your equity, minus any outstanding mortgage balances, and use your property as collateral.
The key difference is how you receive the funds, which is access to a revolving line of credit with a variable interest rate. You may borrow from the line of credit during a draw period that usually lasts up to 10 years. Then you enter a repayment period where you pay down any remaining balance.
Cash-out Refinance
A cash-out refinance allows you to take out a new mortgage for more than you currently owe, pay off the first mortgage and keep the difference in cash. Lenders typically let you borrow up to 80% loan-to-value (LTV).
This option rolls both the mortgage and the borrowed cash into one loan, which streamlines your monthly payments. And because the cash-out refinance is a first mortgage, the eligibility requirements may be more flexible compared to a home equity loan or HELOC. So the cash-out refi could be a good option if your credit score is on the lower side or when mortgage rates are low.
Should I Use My Home Equity?
Home equity loans and HELOCs often provide large borrowing amounts, long repayment terms and relatively low rates, making them a clear winner for some borrowers. But they do come with some drawbacks. Here are some pros and cons to consider before getting one of these loans:
Pros of Using Home Equity:
Pros
- Lower interest rates compared to unsecured loans
- Large borrowing limits
- Long repayment terms
- Interest may be tax-deductible
Cons
- Puts your home at risk
- Drains the equity you’ve built
- Could overburden your finances
- Home values can change
Frequently Asked Questions
Is it a good idea to take equity out of your home?
Tapping your home equity may be a good idea if you use the funds to get ahead financially. For instance, you could consolidate debt using a home equity loan with a lower interest rate, which helps you save money and streamline your budget.
How can I build equity in my home?
You build equity in your home as you make mortgage payments, since a portion of the payment goes toward paying down your principal. Your home may also naturally gain equity as home values in your area increase.
What does equity mean in a house?
Equity is the portion of your home that you own. You can calculate your equity by taking the home’s current market value and subtracting the balance on your mortgage. So if your home is worth $500,000 and you have $300,000 left on your mortgage, then you have $200,000 in equity.
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