Have you ever wondered what it meant when someone asked how much equity you have in your home? You’re not alone. A home equity definition and the financial details of home buying and home ownership are challenging to most people.
Fortunately, it’s not hard to understand home equity when it’s explained the right way. Once you’ve built some equity in your home, you can sell it for a profit and buy a new home – which is always nice!
Here’s what home equity is, how to build it, and what you can do if you have some
A Home Equity Definition
Almost no one can afford to buy a home in cash unless they’ve won the lottery lately. Instead, you go to a bank and get a mortgage to buy the home.
The mortgage will be based on the bank-assessed price of the home. You will probably also put some money toward a down payment, which will reduce the size of the mortgage you need.
When you start out, the bank owns most of the home’s value, or “equity.” You might have some equity depending on the size of down payment you made. However, most of it — if not all of it — was covered by the bank, so they have the equity in the beginning.
You can determine your home equity at any time by subtracting the amount you owe on the home from the market value of the property.
How Does Home Equity Increase?
Home equity can increase in two ways. First, as you pay off your mortgage, you own more and more of the home’s value. Perhaps in the beginning, 80 to 95% of the home’s equity belonged to the bank. After a few years, that number will be lower, and the rest will belong to you.
Another way your equity can increase is if the overall value of your home increases. For instance, let’s say you bought a home for $200,000 and the bank loan was $190,000 because you qualified for a lower down payment.
After a few years, suppose your mortgage is $150,000 but your home value has gone from $200,000 to $210,000. Now your equity is $60,000.
Why Does Home Equity Matter?
Why does it matter what portion of your home you own?
One reason, of course, is because when you sell your home you have to pay off your mortgage before you can purchase your next house. The more equity you have, the more money you’ll keep when the sales transaction is done — especially if you can get a reduced real estate commission fees.
On the other hand, maybe you want to stay in your house but you’d like some financial flexibility. You might need some funding to pay off debt or to help a child go to college. Your home equity can serve as the source for a low-cost loan.
Two Types Of Home Equity Loans
If you want to use the equity in your home to fund your current needs, there are two ways to do it. There’s a traditional home equity loan and a home equity line of credit (HELOC).
Traditional Home Equity Loan
First, you might think about a traditional home equity loan. This type of financing allows you to take some or all of your home equity as a lump-sum, and then repay it over time.
In this case, you’ll essentially have two mortgages – your original one, and your home equity loan. You’ll have to pay both, although your lender may be willing to put the two together so you only have one (larger) payment.
This can be very challenging if you get sick, lose your job, or face other financial hardship. Unfortunately, you may lose your home if you can’t repay your loans.
Home Equity Line of Credit (HELOC)
Another option that can be less risky is a home equity line of credit. With a HELOC, you have a credit line available to you that you can use and then pay off, and it becomes available to use again. It’s as if your home has turned into a low-interest credit card.
A HELOC allows you to only use what you need, when you need it, rather than committing to a larger lump sum. It can be a great way to access your equity without using it all up at once.
Both a traditional home equity loan and a HELOC are intended for a shorter period of time, so once they’re finished you can access your equity again.
Building Wealth Through Equity
Many people simply keep their equity in case they have future needs. There’s nothing like the freedom of living in a home that’s completely paid off or having access to funds when you need them.
Now that you know the home equity definition, you can see how a house can be a “forced savings plan” of sorts. You have to pay the mortgage, but you gain equity when you do. Over time, that can pay off in significant ways. If you want to learn more about how to build equity, talk to a Clever Partner Agent.