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What Is Home Equity?

Home equity is basically how much of your home you actually own. It’s calculated by taking the appraised value of your home and subtracting the balance remaining on your mortgage. This is your home equity. It matters because you can borrow against this money to improve your home and raise the property value or pay off high-interest debt. A financial advisor can help you make the most of your home equity.

Find out now: How much house can I afford?

How Home Equity Works

Now that you know what equity means, you may have heard that you can tap into it. You may borrow up to a certain percentage of it. We’ll explain. Let’s say you have a $500,000 house. And you have $200,000 left on your mortgage. Thus, your home equity is the difference or $300,000. This doesn’t mean you can just go to your bank and ask for $300,000. Depending on your credit history and other factors, the bank may let you borrow up to a certain percentage of it.

For example, your bank may let you take out a home equity line of credit (HELOC) or a home equity loan.

Related Article: Home Equity Loan Dos and Don’ts for Millennial Homeowners

Home Equity Line of Credit (HELOC)

A HELOC is essentially a line of credit that’s usually worth up to 85% of your home’s value minus the remaining balance of your mortgage. In reference to the above example, your bank may let you take out a $225,000 HELOC (85% of $500,000 – $200,000).

You can use this money for just about anything. But you may benefit from using the HELOC to fund a home renovation that would increase your property’s value. Maybe you want an outdoor kitchen, a fire place or an Instagram-worthy patio for major curb appeal. This way you can enjoy a more luxurious home and potentially earn a bigger profit when you’re ready to sell.

Home Equity Loans

These types of loans come in two varieties. With a traditional home equity loan, your interest rate remains fixed. With a home equity line of credit (HELOC), your loan comes with an adjustable interest rate.

By getting either type of loan, you’d essentially be taking on a second mortgage. Under the terms of a home equity loan, your lender would convert your equity amount into a lump sum of cash money that you could then use for whatever you’d like.

You’d be risking a lot, though, if you lose your job or contract a serious illness that leaves you with huge medical bills. Your house becomes your collateral. That means that by defaulting on your home equity loan, you’re giving your lender the opportunity to seize your home and allow it to go into foreclosure.

The same thing could happen if you have a HELOC. The major difference between the HELOC and the standard home equity loan is that with the former type of mortgage, you call the shots and determine how much of the loan to use at one time. Your interest rates therefore can fluctuate on a monthly basis.

Unlike primary mortgages that tend to be paid off over a 30-year period, home equity loans and HELOCs are often used for a shorter amount of time. If you needed another mortgage for short-term projects like remodeling a few rooms in your house and replacing light fixtures, you could try to apply for a five-year loan.

Related Article: Pros and Cons of Tapping Home Equity to Pay Off Debt

Using Your Home Equity to Buy a New Home

What Is Home Equity?

What’s the point? Why should anyone care about their home equity? If you want to sell your home,  you can have your equity turned into cash. Then, you can take that money and use it as a down payment for a new house.

And once your equity reaches a certain level, it’s possible to qualify for a home equity loan or a home equity line of credit. Maybe you’re ready to remodel your master bedroom or expand your garage so that there’s room to store your new car. Or perhaps you’re approaching your 70’s and you need an easy way to fund your retirement. Applying for a home equity loan is one way of meeting your goals.

The Takeaway

What Is Home Equity?

Your equity reveals the percentage of your home’s value that you can rightfully claim as your own. If you’re a homeowner, simply making your mortgage payments on time each month is a quick way to build your equity.

Revolving credit usually has more of an influence on your FICO credit score than installment loans do. So if you need a way to finance your child’s college education or your own retirement, using the equity in your house to get a home equity loan could be a better alternative in the long run to taking on more credit card debt.

Also, compared to the rates that are attached to credit cards, your interest rates will likely be lower through a home equity loan. And the interest on your loan could be tax deductible if you meet the criteria outlined by the IRS.

Tips on Using Home Equity

  • If you have a small child, you can use a HELOC to fund a 529 college savings plan. These work like 401(k)s. Your investments grow tax free and it benefits from compounding.
  • If you have enough equity in your home, you can turn it into a large line of credit or lump-sum. But you must use this money wisely and pay it back or risk losing your home. A financial advisor can help you make the most out of your home equity. Our SmartAsset financial advisor matching tool can connect you with up to three advisors in your area. You can review their qualifications and schedule interviews before deciding to work with one.

Photo credit: ©iStock.com/alephx01, ©iStock.com/ayo888, ©iStock.com/Mark Bowden

Amanda Dixon Amanda Dixon is a personal finance writer and editor with an expertise in taxes and banking. She studied journalism and sociology at the University of Georgia. Her work has been featured in Business Insider, AOL, Bankrate, The Huffington Post, Fox Business News, Mashable and CBS News. Born and raised in metro Atlanta, Amanda currently lives in Brooklyn.
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