What Is Home Equity? 3 Key Things to Know

When you pay your mortgage on time each month, you’re lowering the amount you owe to your lender. Assuming your home value remains the same, this will gradually increase your home equity over time.

Home appreciation can happen in two ways – through market appreciation or forced appreciation. As the name implies, market appreciation occurs when your home value grows as a result of favorable conditions in the housing market. But home value can go up or down. A housing market downturn, for instance, may depreciate your home value – and thereby, decreasing your equity.

While market conditions are out of our control, you could add value to your home by making quality upgrades or renovations (aka, “forced appreciation”). Improvements may include things like remodeling your kitchen, adding an extra room, updating the flooring, etc.

Good to know: Before jumping into a renovation, understand the costs and potential value it could add to your home. It’s a good idea to do some research to see what kind of renovations would be most valuable for a home in your area. You may also want to speak to a realtor for their insights into the local market.

It’s also important to keep up with the maintenance of your home. A poorly kept home can make it harder for you to sell it down the road.

3. Why is home equity important?

Home equity can help you build wealth over time: If the value of your home goes up, you could sell it for a profit and put that money towards something else – perhaps, a bigger home or your retirement savings.

You may also be able to access your home equity to help you achieve other financial goals such as debt consolidation, home improvement, or purchasing a second home.

There are three common ways of accessing your home equity – through a home equity loan, home equity line of credit, or cash-out refinancing.

Home equity loan 

With this type of loan, you’re essentially taking out a second mortgage on your home, using your home equity as collateral. Home equity loans usually come with a fixed interest rate. If your application is approved, you’ll receive a one-time, lump-sum payment from your lender. You’ll repay the loan in installments based on the terms of your loan. Keep in mind that this process and the monthly payments are separate from your existing mortgage payments.

Good to know: Since you’re borrowing against your home equity, consider this option carefully and understand the potential risks involved. Be aware if you fail to pay back your home equity loan, your lender could foreclose on your home. As a general rule, before taking on any new debt, be sure to carefully review the terms and potential fees involved.

Home equity line of credit (HELOC)

With a HELOC, you receive a revolving credit line from which you can borrow money (up to a certain limit) within a specified period of time known as the “draw period.” Under this arrangement, your home equity is also used as collateral for the line of credit. But unlike a home equity loan, many HELOCs usually charge a variable interest rate.

HELOCs typically come with minimum monthly payments based on your current balance, which you’ll have to make during the borrowing period. At the end of the borrowing or draw period, you’re required to repay your full balance. 

Good to know: Be sure you’re able to keep up your payments before taking out a HELOC. If you fall behind on payments, you could lose your home. Understand the terms and conditions as well as any potential fees. Some HELOCs may require you to borrow a minimum amount when the credit line is open.

Cash-out refinance

Cash-out refinance replaces your existing mortgage with a new mortgage that has a higher loan amount. The idea is you’d use the new, larger mortgage to completely pay off your existing mortgage. You would then “cash out” the difference and use that extra money however you like.

Consider this example: You own a $500,000 home that has a mortgage balance of $100,000. This means you have an equity of $400,000. You’d like to use $100,000 of that equity towards a home improvement project. When you applied for refinancing, you were able to take out a new $200,000 mortgage loan. You’d use that first $100,000 to pay off your existing mortgage. The other $100,000 (minus any closing costs and fees associated with the refinance) that’s left over is yours to cash out to put towards your renovation.

Be aware that the amount you may borrow is based on your home equity, and you typically cannot borrow all of your available equity.

Good to know: Keep in mind that refinancing means you’re essentially taking out a new mortgage loan to replace the old one, so the terms of your original mortgage no longer applies. Your loan terms will be based on the new mortgage, which could come with a higher or lower interest rate as well as its own closing costs and other fees.  

A final word

If you’re thinking about tapping into your home equity, review your options carefully. Home equity loans, HELOCs, and refinancing come with many considerations – upfront costs, fees, as well as potential risks. Make sure you’re in a financially stable position to leverage those options. Connect with a financial advisor or a home equity expert if you have questions about your specific circumstances.