What Is Home Equity?

One major perk of owning a house is building home equity in it. But what is home equity and why is it important? We'll show you how to calculate your home equity, and review why having it can benefit you.

What is home equity?

Home equity refers to the amount of your home that you own outright. Most people who buy a home don't pay for it all at once. Rather, they make a down payment and finance the rest with a mortgage. The equity in your home is the difference between what you owe on your home and what it's currently worth.

When you first buy a home, you may not have a lot of equity, but over time, your equity might increase. That's because as you pay down your mortgage's principal, you own more of your home outright.

Also, property values tend to increase over time. If you buy your home for $300,000, but through the years, its value rises to $400,000, you'll gain a lot more equity.

How to calculate home equity

Calculating home equity is pretty simple:

• Take the current value of your home (what it would sell for today).
• Subtract your remaining mortgage balance.
• The result is the amount of equity you have.

Say your home is currently worth $300,000, and you owe $240,000 on your mortgage. You're left with $60,000 in home equity. Home equity can be expressed in percentage form as well. In this case, that $60,000 of $300,000 means you have 20% equity in your home.

What can home equity do for you?

Not only can you use your home equity if you purchase a new home, you can also borrow against the equity you have in your property.

Imagine you're looking to upsize your home, and you have $100,000 worth of equity in your current property. If you sell that home and collect that $100,000 as profit, you could use that money as a down payment on a new home.

You can also use home equity to borrow against your home. You have two options: a home equity loan or a home equity line of credit (HELOC).

Home equity loans

With a home equity loan, you borrow a lump sum of cash and pay it off over time. The benefit of a home equity loan is that you generally get a lower interest rate than with other types of loan. Plus, you often get approved for a home equity loan even if your credit score isn't great.

The reason? With a home equity loan, your home itself is collateral to secure the loan. A lender who gives you a home equity loan takes on limited risk, because if you fail to make your payments, that lender could eventually force the sale of your home via foreclosure and get the money it's owed. That's why a home equity loan is considered a "second mortgage."

That speaks to the danger of a home equity loan. If you fall behind on your payments, you risk losing your home. But a home equity loan should come with a fixed interest rate, so your monthly payments are predictable. That could make them easier to manage.

Many homeowners use home equity loans to improve their properties, but you can use them for any purpose. You can use the proceeds to pay off other debt or cover the cost of education for your children if you so choose.

Home equity lines of credit (HELOCs)

With a HELOC, you don't borrow a lump sum. Rather, you get approved for a line of credit based on your home's equity. You can draw from that line of credit as needed within a preset time frame -- usually five to 10 years. You're only charged interest for whatever part of that line of credit you access.

As is the case with a home equity loan, you can take out a HELOC for any purpose. But in the context of home renovations, a HELOC can be a smart choice. Home improvements can be tricky to budget for. By getting access to a line of credit rather than committing to borrowing a preset sum, you give yourself more flexibility.

Like home equity loans, HELOCs are secured by the properties they're tied to, so if you fall behind on your HELOC payments, you risk losing your home. Also, HELOCs tend to come with variable interest rates, so your monthly HELOC payments could change over time. But HELOCs are also fairly easy to qualify for if you have the equity in your home, and you generally pay less interest on a HELOC than on other types of loan that don't relate to your property.

Cash-out refinances

With a cash-out refinance, you borrow more than your remaining loan balance and get the rest in cash to use as you please. If you owe $200,000 on your mortgage, but your home is worth $300,000 and you want to borrow $20,000 to start a business, you can use your home equity to take out a new loan for $220,000. The first $200,000 pays off your existing loan, and the rest of that cash goes to you.

How to build more home equity

There are different steps you can take to increase the amount of equity you have in your home.

1. Make a higher down payment at closing

Most mortgage lenders require at least a 10% down payment at closing, though your lender may want more or less. It's generally good to put down at least 20% of your home's purchase price when you finalize your mortgage, because that helps you avoid private mortgage insurance, a costly premium that makes owning your home more expensive.

But putting down at least 20% also gives you more instant equity in your home. And the higher the down payment you make, the more equity you have.

2. Make more than your minimum monthly payment

You're usually allowed to put extra money into your mortgage each month. If you increase your mortgage payment, you pay down your loan's principal faster and build equity more quickly.

You can also make lump-sum payments toward your mortgage as you're able. If you get a tax refund or a bonus at work, for example, and you give that money to your lender rather than spending it, you'll build more equity sooner.

3. Improve your home

The more your home is worth, the more equity you can gain. By renovating your property or making certain kinds of upgrades, you can increase your property's value, which, in turn, can give you more equity.

4. Stay in your home longer

Home values don't always grow over time, but often, they do. Staying in your home for many years could result in more home equity for you.

The bottom line on home equity

Home equity is a valuable financial tool you can use to your benefit. And the best part? As your home gains value, you gain more financial freedom without having to do anything at all.

Still have questions?

Here are some other questions we've answered:

• Down Payments: What They Are & How They Work
• Home Equity Loan vs. HELOC
• No Appraisal Refinances: Do You Qualify and Is One Right for You?