What is Home Equity?
If you are looking to purchase a home or simply planning for the future, one question on your mind might be: what is home equity?
Home equity is the value of your financial interest in your home, and it considers both the property’s current market value and your stake in the ownership. There are two factors that influence a property value and your equity stake in it.
- Your equity on a property depends on any payments paid towards the mortgage
- The fair value of the property fluctuates with the housing market
Every time you make a payment towards the house mortgage in terms of principal, you build more equity. Similarly, if the surrounding neighbourhood real estate value increases, so will your home equity. You can also increase the property value by renovating the house itself with upgrades. While the equity can increase, the opposite is also true. In a recession, property values typically see a drop over time. Similarly, if you refinance your mortgage to borrow additional money, that can also decrease the home equity.
How to Calculate Home Equity
While it may seem daunting to calculate your home equity, it is actually pretty straightforward.
If you bought a $850,000 home with a 20% down payment, which is $170,000. Your mortgage needed to finance the house would be $680,000. Your home equity can be calculated as:
Home Value – Outstanding Mortgage = Home Equity
$850,000 – $680,000 = $170,000
Assuming over the next 5 years, the real estate market has been booming, increasing the property value by $70,000. Let’s also assume that within the next 5 years, you were able to pay off $50,000 additionally towards the mortgage. Your home equity with updated numbers would be as follows:
Home Value – Outstanding Mortgage = Home Equity
$920,000 – $630,000 = $290,000
How Can I Use My Home Equity?
One huge perk of home equity is that it can be used towards other things. Since it is your money, you get to choose how to use it. This is known as a home equity loan and is taken against your home. This means that the property acts as collateral and will often get you a lower interest rate compared to a personal loan or line of credit. This loan can be used towards anything you want. For example, you can take out a portion of the funds to renovate, invest in another property, or pay for your children’s education.
Different Home Equity Loans
There are several different loans that can be taken against the property. Let’s explore these further.
Home Equity Line of Credit (HELOC)
A home equity line of credit essentially puts the value of your home in an accessible account form. This line of credit can be accessed at any time. A HELOC is used similar to a credit card. While you must make monthly payments towards it, it has a lower interest rate and a higher limit. You can set limits to how much you want to access but it cannot be more than 80% of the property value.
Refinancing
Another way to access your home equity is by refinancing your mortgage. This means you can borrow more money on top of the mortgage. The maximum amount you can borrow cannot exceed 80% of the total property value minus the balance remaining on the mortgage. When you refinance, you can use it towards consolidating debt with a higher interest rate and can be a good option compared to a second mortgage if you want to avoid fees.
Second Mortgage
As intuitive as it sounds, a second mortgage is an additional mortgage on top of your primary. Second mortgages tend to have higher interest rates and cannot exceed 80% of the property value. The higher interest rate comes from the lender prioritizing the repayment of the primary mortgage which makes the second mortgage more risky. One benefit from taking a second mortgage is that you withdraw the home equity as a lump sum in cash which can be used towards something else.
Advantages and Disadvantages of a Home Equity Loan
If you are looking to access cash through your home equity, let’s explore some pros and cons of it.
Pros
- Easier Long Term Approval Process – If you were approved for a home line of equity, you don’t need to re-qualify unless you want to take our more than your limit.
- Lower Interest Rate – Since a home equity loan is taken against your property as collateral, it is considered a secured loan which offers a lower interest rate.
- Flexibility in Funds Borrowed – Since the home equity belongs to you, you can use the funds as you please.
Cons
- Decrease in Property Value – Since the property value is dependent on the market value. If the property value drops, you would end up owing more than what your home is presently worth.
- Potential Fees – When taking out a second mortgage, you may need to pay fees for legal and appraisal documents. Similarly, when refinancing a home, you will need to pay a mortgage penalty for the funds you withdraw.
- More Debt – The more money you borrow against your home equity, the more debt you are getting into.
While there are both pros and cons to taking a home equity loan, it is important to assess your needs properly and be comfortable in your financial goals. A good idea is to speak to a financial advisor about what is your best option.
Now you know what home equity is, how to calculate it, and how to take advantage of your asset to build further home equity via a home equity loan.
If you are looking for more information, check out our Personal Finance Guides that includes understanding credit and debt.
Deciding whether to buy or rent? Check out this article to help you decide.
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