What is home equity?

Understanding home equity

“Home equity is the value of your home between the estimated market value and any funds you owe on it (mortgage, tax, lien, etc.),” said Rebecca Awram, a mortgage advisor at Seniors’ Lending Centre in Surrey, British Columbia. “For example, you gain equity in your home each time you make a payment toward the principal balance of the mortgage loan.”

When you buy a home, most lenders require some form of down payment (an upfront cash payment calculated as a percentage of the home’s sale price), which gives you equity from the beginning. As you make mortgage payments over time, your equity increases until the loan is paid in full. Once you’ve paid off the mortgage, you’ll have 100% equity in the home.

You can also borrow against the equity in your home through a home equity line of credit (HELOC) or a home equity loan.

Factors that affect home equity

There are a few factors that can increase (or decrease) the equity in your home. Some factors are within your control, while others are simply a function of the real estate market.

How to calculate home equity

To calculate your home equity, use this formula:

Home equity can be expressed as a percentage of your overall home value, or as a dollar figure.

For example, if you buy a home with a 20% down payment, you instantly have 20% equity in your home. So, for a $400,000 home purchase with a $80,000 down payment, the mortgage balance is $320,000 and you have $80,000 equity in the home.

After one year, let’s say you’ve paid down $12,000 of the principal (remember that equity is only based on the principal paid, not interest). Then, your equity would be $92,000, or 23% of the home’s value.

Note: Your home equity is lower if you have a second mortgage on the home or other loans secured by the home.

How to build your home equity

Building your home equity helps increase your net worth and gives you the ability to access that equity for future investments or improvements to your home.

Here are a few ways you can build home equity:

• Down payment: When you purchase a home, mortgage lenders typically require a down payment. The larger your down payment, the more home equity you have right away.
• Additional mortgage payments. “You want to stay on course with all your mortgage payments and even consider making [additional] prepayments if your mortgage contract allows,” said Awram. “A prepayment will be an extra payment that you put toward your outstanding loan balance to help you pay down the loan faster than outlined by your mortgage amortization period.”
• Strategic home improvements. Improving your home can increase its fair market value and thus earn you additional equity in your home. But not all improvements help your home value, so it’s important to be strategic about the upgrades you choose.
• Maintain your home. Simply maintaining your home over a long period of time can lead to home appreciation. Home values tend to rise over time, and keeping it maintained can lower your repair costs and help it grow in value.

You can do many of these simultaneously to increase your equity, such as making additional mortgage payments and home improvements. Or you can simply pay down your mortgage while the value (you hope) improves with the market over time.

For example, if you buy a home that’s worth $300,000 and have a $240,000 mortgage balance, your beginning equity is 20%, or $60,000. If the market value of the home increases to $350,000 within a few years, and your mortgage balance is now only $220,000, you now have home equity of around 37%, or $130,000.

How to use the equity in your home

Once you have some equity, you can use it as collateral to borrow money. These funds can help to make home improvements, pay off (or consolidate) other debts or pay for a child’s college tuition, for instance.

Home equity loans and HELOCs

A home equity loan lets you borrow a specific amount of money at a fixed interest rate. Home equity loans generally offer lower interest rates than credit cards or personal loans because the loan is backed by collateral (your home).

A home equity line of credit (HELOC) also uses your home as collateral but is revolving credit, which means the funds aren’t distributed upfront. Instead, you can withdraw funds up to your limit over a period of (usually) five to 10 years. You may prefer a HELOC if you anticipate having to pay irregular expenses in the short term.

Keep in mind that your home is the collateral for home equity loans and HELOCs, which means you could lose it if you stop making payments.

Reverse mortgages and refinances

You can also access your equity through a reverse mortgage or a cash-out refinance. A reverse mortgage is a loan for older homeowners (usually 62 and older) who want cash to supplement retirement income.

With this type of mortgage, you can receive the funds in a lump sum, in fixed monthly payments or as a line of credit. You don’t pay the money back as long as you continue to live in the home. Reverse mortgages can be complicated, so make sure you understand the paperwork in full before you sign, and watch out for reverse mortgage scams.

Another option is to replace your existing mortgage with a cash-out refinance. A cash-out refinance essentially replaces your old mortgage with a new loan that is larger than what you currently owe, with the difference in cash, which you can use for many purposes.

Both reverse mortgages and cash-out refinances require you to pay closing costs, so you’ll want to consider this additional expense before you borrow.

» MORE: Reverse mortgage vs. home equity loan vs. HELOC

Bottom line

Home equity is the value of your home minus the balance of any loans using the home as collateral. Your home equity increases when you make home improvements or when market forces increase the property value. Building equity in your home increases your overall net worth and makes it easier to borrow money.

Borrowing against your home equity has risks, though, and you could end up owing more on your home than it’s worth if the value drops. Home equity is an important factor in your overall financial plans, but it’s not a substitute for cash in the bank.