You’ve heard of home equity loans, home equity lines of credit and maybe you’ve read the studies on how home equity is the pathway to wealth.
It’s one of those real estate terms that often confuses people so today, we’ll do our best to clear the confusion and elaborate on just what is “home equity.”
What is equity?
Equity is a term used in several industries. It may refer to stock, or shareholder’s equity. In real estate, equity is “… the difference between the property’s current fair market value and the amount the owner still owes on the mortgage,” according to the experts at Investopedia.com.
When selling real estate, equity is defined as “The amount that the owner would receive after selling a property and paying any liens and costs to sell.”
The simple equation for equity looks like this:
Total Assets − Total Liabilities – Cost to Free-up Equity = Net Equity
If your home (the asset) has a current market value of $250,000 and you still owe $200,000 on the mortgage (the liability), and the cost to sell your home is $14,000, then your net equity is $36,000.
Equity, by the way, isn’t fixed; it can naturally fluctuate according to market conditions. Building equity, however, is far more common than losing it.
On a new loan each payment you make goes primarily to pay the interest. As the loan ages, however, more of the payment goes to whittle away at the principal. Every house payment, however, builds equity.
Making a large down payment when you buy the home provides what some refer to as “instant equity.” Not only do you build instant equity with that large down payment, but your monthly payments will be smaller than they would be had you made a smaller down payment.
Another way to build equity quickly is to make larger house payments every month. “Making additional principal payments will shorten the length of your mortgage term and allow you to build equity faster,” according to the pros at AmericanFinancing.net.
They go on to offer an example: “Consider your loan amount is $300,000 with an interest rate of 4% and a 30-year loan term. If you pay $150 additional toward the principal each month, you can expect to save $40,282 and pay off your mortgage almost 5 years earlier.”
There are pros and cons to this strategy, however, so consult with your financial adviser before taking action.
Getting your hands on that equity without having to sell the home
The common way to use your equity is for a down payment on a new home when you sell your current home.
But you don’t need to sell to get access to your home equity; there are numerous ways to borrow against that equity.
The home equity loan is a second mortgage. The amount of equity you borrow against creates a new loan. Each month, you’ll not only have a mortgage payment, but a second loan payment as well.
The maximum amount you can borrow with a home equity loan is typically 85 percent of the equity in your home, according to the Federal Trade Commission (FTC). Learn more about the home equity loan on their website, at FTC.gov.
A HELOC, an acronym for home equity line of credit, is a more flexible type of loan that acts more like “… a revolving line of credit, much like a credit card,” according to the FTC’s website.
Borrow on an as-needed basis, using either a credit card (that the lender supplies) or by writing a check. “… you make payments only on the amount you actually spend, not the full amount available,” according to the FTC.
HELOCs offer tax advantages that the home equity loan doesn’t, so talk to your financial adviser to get the details.
Refinance: Refinancing is a bit like selling the home in that you can take out a new first mortgage, pay off the old mortgage and take any additional equity in cash. For instance, if the market value of your home is $200,000 and you have a loan balance of $100,000, you can refinance the home for, let’s say, $150,000 and pay off the old loan. Then you can walk away with the additional $50,000 of equity in cash to use as you wish.
Remember that your home is the security for each of these solutions, so always speak with your financial advisor before making a move.
You may also want to get to know the various “Harmful Home Equity Practices” by visiting consumer.ftc.gov and learn about the Three-Day Cancellation Rule.
If you’re thinking of selling and want to know your home’s value and the amount of equity in your home, feel free to reach out. I’ll be happy to help – no cost or obligation.
The author, Rick Sheppard, is a licensed real estate broker with RE/MAX Achievers, Inc in Pennsylvania and a 32+ year veteran of the real estate trenches. He knows a lot because he’s seen a lot. If you have any questions about this or any real estate related topic, feel free to contact Rick at [email protected] and he’ll do his best to answer your questions.