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Home equity often comes up when you're applying for a loan. You might see home equity loans advertised, and lenders might ask you how much equity you have and whether you want to use it as collateral.
But even if you're not looking to borrow any money right now, home equity is still an important concept for understanding how much of your home's value you own outright and how much you still need to repay to your mortgage company or a bank.
In this article, we'll cover what home equity is and how to calculate it. We'll also talk about the reasons home equity can go up or down. And we'll look at some strategies for building equity.
What is home equity?
Home equity is the part of your home's value that you don't have to repay to a lender.
If you just took out a mortgage with a 0% down payment, you don't have any home equity yet. That's because in this situation, you need to repay the entire amount your home is worth.
On the other hand, if you've finished paying off your mortgage and you aren't borrowing against your home through a home equity loan or a home equity line of credit, you have 100% equity. In this case, the entire value of your home is yours, and you don't owe any money on the property.
Many people will find themselves somewhere in the middle, having built up equity but with a mortgage balance they still need to pay off.
How do you figure out how much equity you have?
To find your home equity, start with your home's current value. Remember that this may be different from the price you originally bought the house for. Getting a precise dollar amount might require hiring an appraiser, but to do some back-of-the-envelope math you can always use an estimate from an online home value calculator.
Next, see how much you owe on your home. Add up your outstanding mortgage balance and the remaining balances on any home equity loans or home equity lines of credit you've taken out. This is the total you have to repay.
Then, subtract the amount you have to repay from your home's value.
For example, if your home is worth $300,000, you have $120,000 left on your mortgage and you have a $30,000 balance on a home equity loan, your equity is $300,000 - ($120,000 + $30,000) = $150,000.
Dividing that answer by your home's value shows that you have 50% equity.
Why does home equity matter?
Equity is important for a few reasons. First, when you build equity, you're raising your net worth. Building equity can put you in a better position to pursue your goals and help protect you against financial setbacks.
Once you've amassed enough equity, you might be able to borrow against it with a home equity loan or home equity line of credit. Using your home equity as collateral could get you a better interest rate than you'd be charged on a personal loan or a credit card.
And if you use equity as collateral, you might be approved for a larger loan amount than you would otherwise qualify for. So home equity potentially offers a way to finance upgrades to your home or other big purchases.
How much equity you have affects how much cash you can get from selling your home. If you sell, the money paid by the buyer first goes toward paying off your mortgage as well as any outstanding balances on home equity loans or home equity lines of credit. It also pays off other liens, or legal claims to your property, if there are any. And it covers your real estate agent's commission and other costs of the sale. Then, you get to keep what's left over.
So if you have a lot of equity in your home and you decide to sell, you might walk away from the transaction with a significant sum that you could use toward the down payment on your next place. But if you haven't been able to acquire much equity, you might get little or no profit from selling your home. It's important to be aware of how much equity you have before deciding to sell so that you understand how much of the proceeds you can expect to pocket.
How does equity grow?
Your equity goes up when you pay down the principal of your mortgage or of any home equity loans or home equity lines of credit that you have on your home. Paying interest doesn't add to your equity.
Your equity also grows when your home's value goes up. Many things can change the value of your home, but some significant ones are supply and demand in the housing market, trends in which features people look for in a home, and whether your location is becoming more popular with buyers. You can also take increasing the value of your home into your own hands.
How long does it take to build equity?
Accumulating equity usually takes several years. In order to work your way up to having full equity in your home, you need to pay off your mortgage plus any other loans or lines of credit for which your home is collateral.
If you have a fully amortizing mortgage, meaning that part of each monthly payment goes toward interest and part pays down your principal, you'll build equity more quickly later in the life of your loan. The repayment schedule for a fully amortizing loan requires a big share of each payment to go to interest in the beginning. Then, as time goes on, the balance between paying the principal and interest gradually shifts, so that principal is a much bigger share of each payment when you come to the end of the loan term.
So at first, your progress is slow, but the pace picks up until you're building equity at a steady clip.
How does equity go down?
Your home equity decreases when you borrow against your home by taking out a home equity loan or home equity line of credit. And your home equity will go down if you get a cash-out refinance, which involves replacing your existing mortgage with a larger home loan.
You can also lose equity if your home's value drops. That could happen if conditions in the economy change, if buyers start to prefer homes in other neighborhoods, or if you don't keep your home in good repair.
Can you have negative equity?
If your equity goes down, it doesn't have to stop at zero. You can end up with negative equity if your home's value falls until it's lower than your mortgage balance. This is known as having an underwater mortgage, and it's a tough situation to be in.
Depending on your state's laws, you might not be able to sell your home while your equity is negative unless you can produce enough cash to pay off the whole amount you owe or unless your lender agrees to let you off the hook for the difference. Selling your home with negative equity is called a short sale, and it will generally hurt your credit. That could make it more difficult to get approved for a mortgage the next time around.
What can you do to speed up the process of building equity?
If you'd like to gain equity faster, there are some steps you can take to speed things up.
Make a larger down payment
If you make a bigger down payment when you buy a home, you start out with more equity. An advantage of making a sizable down payment is that you get a big chunk of equity all at once, rather than having to gradually build it up over time.
Make extra payments
Usually, lenders allow you to pay a bit extra on your mortgage each month if you choose to. If you make additional payments toward the principal, you can pay your loan down faster, which means your equity goes up faster.
This strategy could be especially helpful in the first few years of your mortgage, when a large share of each monthly payment goes to interest. While you'd ordinarily build equity slowly during these years, making extra payments allows you to tackle more of the principal early on.
Just make sure you talk to your lender and specify that you want your additional payments to go toward the loan principal. If you don't have this conversation, your lender might assume you want the money to be used for your next month's payment, in which case part of it would go to interest instead of growing your equity.
Refinance to get a shorter term
Refinancing can allow you to pay off your mortgage sooner and shorten the timetable for building equity. Let's say you've got 20 years left on your mortgage. If you refinance to a new loan with a 10-year term, you're now on schedule to get to full equity in your home an entire decade earlier.
Boost your home's value
Since your equity is the value of your home minus how much you owe on it, another way to grow your equity is to increase your home's worth. You can do this by remodeling or upgrading your property or by getting involved in making your neighborhood a more attractive place to buy a home — such as by collaborating with your neighbors to add greenery or clean up pollution in the area.
Keep in mind, though, that home values depend on a lot of economic factors outside of your control and that your equity may not go up by as much as you'd hope. For instance, remodeling usually raises a home's sale price by just a fraction of the amount homeowners spend on the work. So trying to enhance your home's value is not a surefire way to gain equity.
Home equity may seem like a fairly abstract idea, but it can be very relevant to questions like whether to refinance your mortgage or when to sell your house. Tracking how much equity you have can help you prepare to make sound financial decisions.