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One of the benefits of buying a home is that you can build equity in it and tap into that equity to pay for a major kitchen remodel, eliminate your high-interest credit card debt or even help cover your children’s college tuition.
But what exactly is equity, and how can you use it? Here’s a quick guide to the basics of how home equity works and why it’s so valuable.
What Is Home Equity?
Equity is the difference between what you owe on your mortgage and what your home is currently worth. If you owe $150,000 on your mortgage loan and your home is worth $200,000, you have $50,000 of equity in your home.
Your equity can increase in two ways. As you pay down your mortgage, the amount of equity in your home will rise. Your equity will also increase if the value of your home jumps.
Your equity can fall, too, if your home’s value drops at a rate faster than the speed at which you’re paying down your mortgage’s principal balance.
How Does Home Equity Work?
Here’s an example of how equity can change over time.
Say you buy a house for $200,000. You might come up with a down payment of 10% of your home’s purchase price – which would be $20,000. Your lender will then provide you with a mortgage loan of $180,000.
If your home is worth that $200,000 sales price, you now have $20,000 of equity, or $200,000 minus $180,000.
Jump ahead 2 years. You’ve been making your mortgage payments on time, and you might now owe $170,000 on your mortgage. Maybe your home’s value has jumped too during this time to $210,000.
You now have $40,000 in equity, or $210,000 minus $170,000.
Your home’s value could work against you, too. Say you’ve paid down your mortgage loan to that same $170,000, but your home’s value has actually dipped to $195,000. Now you have $25,000 in equity, or $195,000 minus $170,000.
To determine your equity at any one time, you’ll need to know the value of your home.
Only a real estate appraiser can give an official valuation of what your home is worth in today’s market. You can, though, estimate your home’s value by looking at comparable home sales in your area or by checking with online real estate sales that provide their own home value estimates.
Just remember that these estimates aren’t always accurate and exist just to give you a rough idea of your home’s current worth.
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How To Build Home Equity
Fortunately, there are a number of ways you can build equity in your home.
Make A Big Down Payment
The fastest way to build equity is to come up with a large down payment. The bigger your down payment, the more equity you’ll immediately have in your home.
Say you buy your home for $180,000. If you put down $5,000, you’ll owe $175,000 on your mortgage. That leaves you with $5,000 in equity. If you put down $20,000, you’ll owe $160,000 on a home worth $180,000. That $20,000 in equity is far more impressive than $5,000.
Figuring out how much you can use toward your down payment is a big step in understanding how you’ll build equity in your home. Getting preapproved for a mortgage before you make an offer will help you understand how much of your savings you’ll have to use toward your down payment.
Pay More Than The Minimum
If you want to build equity more quickly, you can always pay more than your required payment each month. Making an extra payment each year on your own or through biweekly payments or even paying an extra $100 a month can help you chip away at your loan’s principal balance as well as help homeowners increase their home equity at a faster rate.
Stay In Your Home 5 Years Or More
You’ll build equity if your home increases in value. Of course, no home is guaranteed to see its value jump, but you will increase your odds if you stay in your residence for a greater number of years.
Plan on staying in your home for 5 years or more if you want to see its value jump enough to give you an equity boost.
Renovate And Add Curb Appeal
You can help boost your home’s value by adding an extra bedroom, renovating that old kitchen or adding a master bathroom. Investing in landscaping and giving your home curb appeal can help too.
How To Use Home Equity
Equity is an important financial tool and one of the greatest financial benefits of owning a home.
You can tap into this equity when you sell your current home and move up to a larger, more expensive one. You can also use that equity to pay for major home improvements, help consolidate other debts or plan for your retirement.
Using Equity To Buy A New Home
Perhaps you’ve lived in your home for 7, 8 or 9 years. Maybe your family continues to grow. Or maybe your job is taking you to a new city. Whatever the reason, you’re ready to sell your home and find a new place to live.
Equity can be your friend as you make this move.
Let’s say the home you’re selling is worth $220,000, and you’ve built $70,000 worth of equity in it. If you sell your home for what it’s worth, you’ll leave the closing table with a profit. You probably won’t get the entire $70,000 in equity you’ve built because of such fees as your real estate agent’s commission and some mortgage closing costs. But you’ll end up with a solid profit that you can then use for a large down payment on your next home.
With this big down payment, you may be able to get into a larger, more expensive home because your mortgage will be smaller. And with a smaller mortgage, your monthly payment will be lower, too.
If your down payment is big enough, your monthly mortgage payment might be smaller than it was with the residence you sold, even if that home was smaller and less expensive.
Using Equity For Your Retirement
If you’re 62 or older and considering retirement, you might explore a reverse mortgage1. With a reverse mortgage, you’ll stop making your monthly mortgage payments and will instead receive money based on the equity in your home.
How much you can borrow depends on your age and how much equity you have in your home as well as current interest rates.
You can elect to receive your proceeds in one lump sum, regular monthly payments or a line of credit. Any combination of the three payment types is also possible.
You don’t pay back your loan unless you sell your home, move out for more than 6 months out of the year or pass away. If you sell the property, you would then use the profits from your home sale to pay back the loan.
If you pass away, your heirs have options. They can choose to sell the home (keeping any profits after the loan is paid off), refinance into a regular forward mortgage or walk away and let the lender sell the home. A reverse mortgage is a non-recourse loan, meaning your heirs won’t be forced to pay back anything more than what they can get from the sale of the home.
Options For Borrowing Against Home Equity
There are three main ways you can borrow against your home’s equity: a home equity loan, a home equity line of credit or a cash-out refinance.
Using equity is a smart way to borrow money because home equity money comes with lower interest rates. If you instead turned to personal loans or credit cards, the interest you’d pay on the money you borrowed would be far higher.
There is a potential danger to home equity lending, though. If you fail to make your payments on time, your lender could take your home through the foreclosure process. This can’t happen when you take out a personal loan or when you charge purchases with your credit cards.
In a cash-out refinance, you refinance for more than what you owe on your mortgage. You again receive this extra money in cash that you can use however you want.
Say you owe $180,000 on your mortgage. You can refinance for $220,000 and then take the extra $40,000 in cash. You will repay the $220,000 total in monthly payments, with interest. How much extra you can include in your cash-out refinance depends on the equity in your home.
With a cash-out refinance, you’ll be borrowing against the equity in your home rather than relying on your credit. This can give you access to greater funds typically with lower interest rates than other types of financing. You typically have to leave at least 20% equity in your home after doing your cash out refinance, so be sure you have enough equity to accomplish your goals.
Once you refinance, you’ll continue to have a single mortgage.
Home Equity Loan
While a cash-out refinance loan effectively replaces your original mortgage, a home equity loan works like a second mortgage.
Say you have $50,000 in equity. You might qualify for a home equity loan of $40,000. Once the loan closes, your lender will lend this $40,000 in a single payment. You can then use this money however you want.
You pay this loan back in monthly installments, with interest, while continuing to make your normal payments on your original mortgage.
Home Equity Line Of Credit
Better known as a HELOC, a home equity line of credit is more like a credit card, only the credit limit is tied to the equity in your home.
If you have $40,000 of equity, you might qualify for a HELOC with a maximum spending limit of $30,000. This means you can borrow up to $30,000, but no more.
As with a credit card, you only pay back what you borrow. So if you only borrow $20,000 on a kitchen renovation, that’s all you have to pay back, not the full $30,000.
The Bottom Line
Understanding how equity works is an essential step in preparing to buy a new home or refinance your current one. By leveraging the equity you build in your home, you’ll be able to consolidate debt, pay for renovations or make updates that increase your home’s property value in the long run.
However, it’s important that you explore your options and choose the right type of home equity financing for your needs. Before deciding on any of these home equity choices, be sure to speak with a mortgage professional who can help you understand the pros and cons of each.
If you’re ready to apply for a mortgage so you can buy a new home or want to refinance your current loan, you can get started online.
|A smarter way to unlock the home equity you already own|
|Free Estimate | Apply in 5 Minutes | Zero Impact on Credit|
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