Help your clients understand home equity—how it works, how to access it, and its benefits. Learn key insights to educate borrowers
Buying a home is one of the biggest financial steps to take for the average American. For many, it's not just about finding a place to live—it’s also a way to build wealth over time. One of the most important concepts to understand as a future homeowner is home equity.
Want to know what this is and how it works? Mortgage Professional America will explore everything you need to know about home equity. We will also discuss how to calculate and boost it.
To our usual pool of readers who are mortgage professionals, this article is part of our client education pieces. This means that it can serve as a valuable tool for any of your clients who are asking about home equity. Feel free to share this with them!
What is home equity?
Equity in a home is the difference between what your home is currently worth and what you owe on your mortgage. For instance, if you owe $200,000 on your mortgage and your property is worth $250,000, then you have $50,000 of equity in your property.
How does home equity work?
If all or some of your property is purchased using a home loan, then your bank or mortgage lender will have an interest in your property. This continues until the mortgage is repaid.
The down payment that you’ve made on your home is the equity that you initially have. Following the down payment, your equity keeps growing with every mortgage payment you make. This is because every payment made reduces the outstanding principal owed.
How home equity increases
There are two ways by which home equity increases. First, the more money you pay on your mortgage, the more the equity in your home will increase. Second, if the value of your home increases, your equity will also increase.
How home equity decreases
Conversely, the equity in your home can also decrease. This can happen if the value of your property falls faster than the speed you’re paying down the principal balance of your mortgage.
How to determine equity in your home
If you want to know how much equity you have in your home, you will have to know the value of your property. One way to get an estimate is by looking at what properties like yours, in your area, have recently sold for.
Home equity formula
We’ll use an example: let’s say that number is $200,000. You would then subtract from that the balance of your home loan. Let’s assume that it is $125,000. That would make your equity $75,000.
In other words, the calculation to determine your equity is as follows:
Let’s say that after two years of making mortgage payments on time, you’ve reduced your home loan balance to $100,000. The value of your home then increases to $210,000. The formula becomes this:
To better understand how this formula works, watch this video:
You should use your home equity wisely, especially when home equity levels remain strong across the US.
What is a HELOC?
Like a mortgage, the amount of equity you have in your home secures the home equity line of credit (HELOC). Unlike a mortgage, a HELOC offers more flexibility. This is because you can use your line of credit to repay what you used, like you do a credit card.
You have the option to use a HELOC to pay off all or portion of your remaining mortgage balance, or for just about any other reason. If approved for a HELOC, you can make mortgage payments before paying your HELOC instead of your mortgage.
Additionally, since HELOC rates are variable, the rate can fluctuate. Repaying your mortgage using a HELOC is like refinancing. However, it lets you reduce your interest rate while avoiding the closing costs that come with refinancing.
Is it a good idea to take equity out of your home?
Whether it is a good idea to take equity out of your house or not will depend on various factors. These include how confident you are that you will make payments on time. Another consideration is if you are using the home loan to make home improvements that will increase the value of the property.
These considerations will change from one homeowner to another. If you do fall behind on payments, there are many risks involved. Before deciding whether to take out a home equity loan, here are some of the risks that you should consider:
- rising interest rates on some loans
- your home is used as collateral
- making minimum payments can get you in trouble in the future
- your credit score may fall
Here is a more in-depth look at each of the risks and how to manage them:
1. Rising interest rates on some loans
HELOCs and home equity loans are the two major kinds of property loans that use your home equity as collateral. The loan terms will depend on each different product and mortgage lender, but a HELOC will typically offer adjustable rates. This means rising interest rates can result in higher payments.
In other words, HELOCs are connected to the prime rate. This means that due to unpredictable interest rates, anyone who borrows on a HELOC may wind up paying a lot more money than they thought.
2. Your home is used as collateral
If you default on a HELOC, you could potentially lose your house, since it is used as collateral for the home loan. This is different from defaulting on a credit card, which simply means your credit is lowered and you will have to pay penalties for any late fees.
Prior to taking out a HELOC or a home equity loan, it is important for you to do thorough research. You need to make sure that your income is high enough to make continuous payments.
Check if you can continue to make regular payments if your income is changed in some way. After asking yourself those kinds of questions and doing your research, you’ll see if a HELOC or home equity loan does make financial sense for you.
If you’re still confused, you might want to engage the services of a competent mortgage broker. Try choosing from any of these top professionals listed on our special reports via Best in Mortgage.
3. Making minimum payments can get you in trouble
Interest-only payments are required for most HELOCs during the first few years. You are allowed to access the credit of the home loan during that draw period. However, you won’t make any progress in paying off the principal of the loan if you only make those minimum payments.
When that draw period ends, you enter a period of repayment where you must pay both on the principal and on the interest. You will no longer be able to draw from the line of credit.
By making minimum payments on the large amount of money borrowed during the draw period, you will likely have an unwelcome surprise after that period ends. That’s when the principal balance will be added to your bill.
4. Your credit score may fall
Your credit score may also be impacted if you open a home equity loan, since that figure has multiple factors. One such factor is how much of your available credit you are using. If you add a home equity loan to your credit report, your credit score could be damaged.
On the contrary, your credit score might be improved if you take out a home equity loan and regularly make monthly repayments.
Using home equity to pay off mortgage: Is it worth it?
If you have built up enough home equity but still have a mortgage to pay off, using a HELOC can be beneficial. This strategy can help reduce your monthly payments and even lower the total interest you pay over the life of your mortgage.
You can use a HELOC to pay off a large portion (or even all) of your existing mortgage. By doing this, you’ll replace one type of debt with another, often at a lower interest rate. This can give you more breathing room in your monthly budget and reduce how much interest you’ll pay in total.
Some homeowners even use their HELOC to consolidate higher-interest debt or pay for home improvements that boost property value. In turn, this can increase your home equity even more.
Do you have experience with home equity? Let us know in the comments below.
