In the third quarter of 2021, the average sales price of homes sold in the US reached a staggering $453,300. That’s a massive increase of $55,500 from the same quarter of the previous year.
With so much money going into buying a house, it only makes sense that you can use yours as collateral for a loan. However, that usually only works if you have enough home equity.
So, how does home equity work, exactly? What does it even mean in the first place, and why should you care?
This guide will get to the bottom of all those questions, so be sure to keep reading!
What Is Home Equity?
Home equity is an owner’s interest in a residential property. According to analysts, the average US homeowner had $153,000 in equity as of the last quarter of 2020.
As a homeowner yourself, you can think of it as your stake in your house. In other words, it’s the portion of your home that you truly “own.”
Another way to define equity is that it’s a home’s current market value (current valuation affects homeowners insurance cost as well), less the liens attached to it. So, if your home’s value is currently $300,000 and you only owe $125,000 on your mortgage, your equity on it is $175,000.
How Does Home Equity Work Then?
Home equity provides you, a homeowner, an asset that you can borrow against in the future. While it’s not a liquid asset, it also adds to your net worth.
Your home equity starts with any down payment you’ve made when you bought your house. For example, suppose you made a 20% down payment on your home that’s worth $300,000. That means you already have a $60,000 home equity, provided your home’s market value is still the same.
That’s another good reason to make the highest down payment you can afford when buying a home. The larger your down payment, the bigger the home equity you automatically get.
From there, you can continue to build equity as you pay down your mortgage loan balance. That’s because part of your mortgage payments goes toward paying off the principal.
Another way for your equity to go up is through property value appreciation. While appreciation rates vary, the national average sits at 3.5% to 3.8% per year.
What Can You Do With Your Equity?
Once you’ve built up enough equity on your home, you can use it to secure a home equity loan or a reverse mortgage. Another option is to use it as collateral for a home equity line of credit (HELOC).
You can then use the funds for almost anything, such as major home improvement or an emergency.
Home Equity Loan
A home equity loan, also sometimes called a second mortgage, is a lump sum loan against your equity. In most cases, lenders charge a fixed interest rate for these loans. You can then pay back what you owe in monthly increments over 5 to 30 years.
Most home equity lenders only allow you to borrow up to 85% of your home’s current value. However, that’s the combined maximum for both the home equity loan and what you still owe on your mortgage.
So, for a home whose value is $300,000, the total you could owe on it is $255,000.
Now, let’s say that you still owe $155,000 on your mortgage. In that case, you could qualify for a $100,000 home equity loan.
Like a home equity loan, a reverse mortgage lets you borrow cash against your home equity, too.
However, a reverse mortgage is usually only available to seniors 62 years or older. Another key difference is that it doesn’t require monthly repayments.
The reverse mortgage loan only becomes due when you, the homeowner, move out of the property. The same goes if you choose to sell your home. If you pass away, the lender gets to keep the house in exchange for the money they lent you.
There are several ways to acquire the funds from a reverse mortgage, with a lump sum being one of the most common. With this, you obtain all the proceeds as soon as your loan closes.
Another option is to have a reverse mortgage lender make annuity payments. In this case, you’ll receive equal monthly payments for as long as you live in the home.
You can also opt for a reverse mortgage with term annuity payments. With this, you and the lender will agree on a loan period, in which you will then receive equal monthly payments. For example, if you choose a 10-year term, you’ll get monthly payments from the lender for ten years.
Home Equity Line of Credit (HELOC)
A HELOC is a revolving line of credit that often comes with an adjustable interest rate. It works like a credit card in that you can keep borrowing up to an approved limit so long as you pay off your balances.
One of the primary benefits of a HELOC is that you can borrow against your limit at any time. In addition, you usually don’t have to pay interest if you don’t use your available funds. Just make sure that your bank or lender doesn’t require minimum withdrawals, though.
Because of those perks, a HELOC can serve as a low-cost source of emergency funds. The downside is that its interest rate can go up any time (unless you have a fixed-rate account). If that happens once you need to tap the funds, you can end up with high-interest payments.
Take Advantage of Your Home Equity
There you have it, the ultimate guide answering your question, “what is and how does home equity work?” Now, you know that it’s a significant homeowner asset and that you can leverage it if you need access to funds. If you’re a senior, you can even use it as an income source.
Either way, your home equity can be a lifesaver during trying times, so be sure to build it up as much as possible.
Ready for more real estate and personal finance tips? Feel free to read our other guides then!