What Is Home Equity? Definition, How It Works And FAQs

What is home equity, exactly?

Here's a quick and easy definition: Home equity is the difference between your home's value and the remaining balance on your mortgage.

Let's dig deeper into:

1. How home equity works
2. How it impacts your real estate investment
3. How you can tap into your home equity using home equity loans¹ and other types of loans

The home equity definition is the amount of ownership a homeowner currently has. This amount equals the difference between your home’s value and the remaining principal balance on your mortgage or any other liens on your home. However, additional factors can affect this calculation, like your down payment when you purchase a home as well as fluctuations in market value.

How To Calculate Home Equity

Let's look at an example of calculating home equity using a fictitious example for a homeowner named Sarah.

Here's a summary of Sarah's story in chart form:

Using A Down Payment

Your down payment (a percentage of your home's total purchase price paid upfront at closing) is a starting point when calculating home equity. 

Sarah purchased a home for $400,000 and put down a down payment of 20%, a total of $80,000 (leaving $320,000 to pay off). Right off the bat, she starts with 20% equity in her home. The more she puts down on her property, the more equity she will have. In other words, if she put down $120,000, she'd have 30% equity in her home.

The same goes for you: The more you put down on your property, the more equity you'll start with.

Using Loan Principal Paid

Your loan balance also goes into calculating equity in a home. The lower your home loan balance, the more equity you have.

Let's say Sarah pays down an additional $50,000 of her mortgage principal through regular monthly payments over a few years. Her principal would be $270,000 after accounting for her down payment and regular monthly payments..

Using Home Value Appreciation

You can also calculate home equity by adding home value appreciation as a factor. The third factor that can influence and impact your home equity market value is the amount of money your property is worth in the current housing market.

Now, let's say the local housing market enjoys an upswing, and her house is worth $500,000. She will gain $100,000 in equity due to external market forces working to her advantage.

Using Home Value Depreciation

You can also calculate home equity using home value depreciation. You'll gain equity if your home goes up in value, but if it falls, you'll lose it.

For example, if the local housing market experiences a downswing instead of an upswing and her house is worth $350,000, Sarah will lose $50,000 in equity.

Ways To Build Equity In A Home

You can control some factors that go into calculating home equity, though you can't control everything, such as market factors. You can control your:

• Down payment amount
• The amount you pay toward your mortgage each month
• Total loan balance

We'll go over a few ways to build equity next.

Make A Larger Down Payment

Making a larger down payment can help homeowners build equity. The more money you can put down upfront on your home loan, the more equity you'll have. There's also another benefit: It's less likely that you'll have to pay private mortgage insurance (PMI).

What is PMI? PMI is a type of insurance that protects your lender if you stop making payments on your home. If you put less than 20% down on your home loan, you must pay PMI as part of your monthly mortgage payment.

You can contact your lender and request that your PMI be canceled once you've reached 20% equity in your home, and your loan servicer often cancels PMI automatically once you reach 22% equity.

Pay Your Mortgage Down

Paying your mortgage down through monthly payments can also help homeowners build equity. Some common techniques include:

• Making biweekly payments
• Increasing monthly payments
• Using an amortization calculator

Paying off your mortgage early helps you accelerate home equity payments and can also help you save thousands in interest payments over the life of your loan. Check with your lender to ensure you won't get charged any prepayment penalty fees.

If you make biweekly payments every 2 weeks instead of a full payment once a month, you'll automatically make one extra mortgage payment per year directly toward your principal balance.

Refinance To A Shorter Loan Term

Mortgage refinancing can help homeowners build equity. Refinancing to a shorter loan term can help you build equity in your property faster because it involves making larger payments to your lender over a shorter period. Refinancing can help you quicken the pace by which you accumulate equity in real estate.

Make Value-Adding Home Improvements

Making value-adding home improvements can help homeowners build equity based on property value. For example, remodeling the kitchen or bathroom can help build long-term value.

Ensure that the upgrades and improvements will increase your property value – not all renovations will increase your home's value. For example, adding a swimming pool may not offer the property value increase that you were hoping for.

Before choosing the home improvements you think will have an impact, speak with a real estate professional to make sure.

Own The Home Long-Term

Owning the home for many years and not selling it early on can allow your home equity to grow. If you diligently make monthly payments, you'll continually build up your home equity until you own your property free and clear.

Ways To Borrow From Your House’s Equity

One of the major benefits of building equity in a home is that you can borrow from your home's equity if you need cash. You can borrow from your home's equity through a home equity loan, home equity line of credit (HELOC), cash-out refinance or reverse mortgage.

Home Equity Loan

You can use a home equity loan, also often called a second mortgage, to borrow from your home equity. A home equity loan allows you to put up your home as collateral in exchange for receiving a lump sum of money from a lender. You can use your loan to upgrade the property, pay for education or other expenses. You repay the money monthly on top of your first mortgage.

Let's go over the pros and cons of home equity loans:

Pros:

• Fixed interest rates and fixed monthly payments
• Lower interest rates than most personal loans or credit cards
• Money comes to you in a lump sum
• No restrictions on how you use your money
• Easier to qualify for than other types of loans

Cons:

• You must pay on both your primary mortgage and your home equity loan
• Selling your home before you pay off your home equity loan means you will make less profit once you receive payment from the sale
• The house serves as collateral for the loan

Home Equity Line Of Credit (HELOC)

A HELOC also allows you to tap into the equity you've built up in your home. However, instead of receiving the money you're borrowing in a lump sum from your lender, you receive your funds through a revolving line of credit like a credit card.

Under a HELOC, your balance carries over from month to month, and there's a maximum limit on how much you can borrow. You'll also have a minimum amount you must pay per month. 

It's a good idea to consider some of the pros and cons of HELOCs:

Pros:

• Only charged interest on your current outstanding balance
• Borrow the amount you need when you need it

Cons:

• Maximum limit on how much you can borrow
• No lump sum of cash
• Monthly payment will fluctuate, so you won't have a standard monthly payment
• Rates increase or decrease based on the market
• House serves as collateral for the loan

Cash-Out Refinance

In a cash-out refinance, you replace your current primary home mortgage with a brand-new mortgage, meaning you'll only have one monthly payment, unlike a home equity loan. You take out a new loan for more than you currently owe your lender and get the difference in cash back after closing.

For example, if you buy your home for $350,000 and pay off $100,000, you have $250,000 left on the original mortgage. Various home renovations will cost you $50,000, so you elect to do a cash-out refinance for $300,000 – $250,000 goes toward what you still owe on your home, and $50,000 goes toward you in cash.

Consider the pros and cons:

Pros:

• Just one monthly payment
• Can use the cash however you want
• Cash comes to you fast, even 3 – 5 days after closing
• Rates are usually lower than any other type of loan against home equity

Cons:

• You'll have a larger loan after you refinance
• It may take you longer to pay off your loan
• Your house serves as collateral for the loan

Reverse Mortgage

A reverse mortgage, also called a home equity conversion mortgage (HECM), is for homeowners aged 62 or older. A reverse mortgage lets you tap into your home equity to pay off the remainder of your primary loan and use the remainder of the money for whatever you'd like, from living expenses to building up savings, paying off debt, etc.

Pros:

• Allows you to access funds and eliminate a monthly payment
• You receive payments from your lender from your excess equity

Cons:

• Leaves you with less equity over time
• You must still pay property taxes and homeowners' insurance
• Usually are very expensive for borrowers because of costs

Ways To Use Money Borrowed From Your House’s Equity

There are unlimited ways to use the money from your home's equity. We'll include a few options, but remember, you're not limited to this list:

• Home improvements: You can tap into your home's equity through a home equity loan, HELOC, cash-out refinance or reverse mortgage to make home improvements. Apply for the type of loan you're considering, wait for the funds to come in and use the money toward your home improvement of choice.
• Buying another home: When you buy a second home, you may choose to sell your original home to have money for the down payment for the new home. You'll sell your original home and pay off the mortgage, and you can put any money you have leftover toward the purchase of your new home and build the equity in that home. Again, the more you put down on a down payment, the more equity you'll have in the home. Remember that you'll have to subtract fees like agent's commissions.
• Debt consolidation: You can use money borrowed from a home’s equity to consolidate credit card or high-interest debt. The cash proceeds can help you pay off high-interest debt like credit card or student loan debt. Check your interest rates to ensure that it's the right move. Your equity loan should carry a lower interest rate than the debt you're consolidating.
• Retirement: You can use money borrowed from your home to fund your retirement. To do so, look for an individual retirement account (IRA) or other plan type. Once you choose the retirement plan that fits your needs, you can funnel the money from your loan into your retirement plan based on the plan's requirements. Make sure to consult with a financial professional and a tax advisor before borrowing money to invest in a retirement account. You need to make sure it’s the best decision and you are aware of any risks of losing your investment.

Home Equity FAQs

Here are a few home equity FAQs to consider before choosing this option.

How long does it take to build home equity?

Building home equity can occur immediately when you put a down payment on your home. Otherwise, you build up home equity a little at a time with each monthly mortgage payment you make. You can have a sizable amount of home equity built up around 5 years as long as you make payments regularly and on time.

You can build your home equity faster by making more frequent principal-only payments, taking shorter-term loans or increasing your down payment on a property. You can also build home equity simply by living in an area with a booming real estate market and enjoying the benefits of your property rising in value.

How soon can I take equity out of my home?

Technically, you can take equity out of your home right away. However, many lenders don't allow this because you may not have enough equity. Ask your lender or loan servicer for more information.

Is using home equity a good idea?

Tapping into your home equity depends entirely on your finances and household situation. Choosing to use or borrow against your home's equity is a big decision, with many factors to consider. A booming housing market might mean it's time to take advantage of your equity by taking out a home equity loan, refinancing or even selling your home. The most important factor is considering what works best for your goals and budget.

How much home equity can I borrow?

Generally, with a 680 credit score, you can access up to 80% of the equity in your home. If you have a 700 score or better, you can access 85%. You can borrow up to 90% if you have a 760 or higher. However, note that other factors, such as your income, loan-to-value ratio and more, come into play.

Can I take equity out of my house without refinancing?

Yes, refinancing isn't the only option. You can borrow from your home's equity through a home equity loan, home equity line of credit (HELOC) or reverse mortgage. We've detailed the ins and outs of those types of loans above.

The Bottom Line

Growing your home equity can help you achieve specific goals. Depending on your needs and financial situation, you can access or borrow against your home equity. Use a home equity calculator to help you understand how much equity you have in your home and which financial choices make the most sense for you.

Ready to take cash out for a project, investment or any other reason? Apply for a cash-out refinance with Rocket Mortgage^® today.

¹ Home Equity Loan product requires full documentation of income and assets, credit score and max loan-to-value (LTV), combined loan-to-value (CLTV), and home equity combined loan-to-value (HCLTV) ratios. Requirements were updated 2/5/2024 and are tiered as follows: 680 minimum FICO with a max LTV/CLTV/HCLTV of 80%, 700 minimum FICO with a max LTV/CLTV/HCLTV of 85%, and 740 minimum FICO with a max LTV/CLTV/HCLTV of 90%. Your debt-to-income ratio (DTI) must be 50% or below. Valid for loan amounts between $45,000.00 and $500,000.00. Product is a second standalone lien and may not be used for piggyback transactions. Product not available on Schwab products. Guidelines may vary for self-employed individuals. Some mortgages may be considered “higher priced” based on the APOR spread test. Higher priced loans are not allowed on properties located in New York. Additional restrictions apply. This is not a commitment to lend.