Home Equity: What It Is And How To Use It
Lauren Nowacki9-Minute Read
October 19, 2021
You may often hear that a home can be a great investment, but what does that mean exactly? So often we focus on the use of a home (living and raising a family), that we may forget that we can actually earn money from our homes. This money comes in the form of home equity.
So what is home equity and what are the many ways you can use it? Read on to learn more.
What Is Home Equity?
How Home Equity Works
There are a few factors that can affect your home equity throughout the time you own the home. Here’s where it starts:
Purchase Price And Down Payment
If you’re required to make a down payment (which is the case with almost every loan), you’ll already start with some equity in the home. The purchase price and your down payment will determine the initial equity.
Let’s say you purchase a $200,000 home and you put down $6,000, or 3% (the minimum down payment required for a conventional mortgage), and you borrow $194,000. In this scenario, you’ll have $6,000, or 3%, equity in the home, when you move in.
As you pay down your loan, you’ll gain more equity in the home. Continuing with the same example, it’s now a few years later and you’ve paid off an additional $14,000. You now owe $180,000 on your mortgage and have $20,000 equity in your home.
As the housing market rises or falls, your home value may change, affecting your home equity. If your home value rises, you gain more equity. If it falls, you lose equity.
In the example above, your home’s value was $200,000 when you purchased it. Now, a few years later, the market is booming and your home’s value is worth $250,000. Just based on the value of the home (and no other factors), you’ll gain an additional $50,000 in equity.
Putting It All Together
In this example, your home value rises to $250,000 and your loan balance decreases to $180,000. You started with $6,000 in equity and over the years, you built $70,000 in home equity.
How To Build Home Equity
While you can’t control everything the market does, there are ways to build equity in your home. Keep in mind, these strategies may take time and could cost money.
Make a Large Down Payment
As mentioned above, the higher your down payment, the more equity you initially have in your home and the less you have to borrow. Keep in mind, too, that paying at least 20% on a conventional loan will get rid of your PMI, which means you can put more money toward your principal balance.
Repay Your Loan
By paying off your mortgage, you’ll have 100% equity in your home. Paying off your mortgage early can help save you thousands on interest as well. Just make sure your loan doesn’t come with prepayment penalties.
While repaying your mortgage takes time and is no easy feat, there are ways to help you do it faster.
Up Your Monthly Payment
When you’re able, put any extra money you have toward paying off your principal loan balance each month. Just make sure that you direct your lender to apply the extra payments to the principal balance only. If you don’t specify what the extra payment is for, the lender could apply it as a prepayment on interest or next month’s mortgage payment instead.
Make Bi-Weekly Mortgage Payments
A biweekly mortgage payment is a payment option that allows you to make half your monthly mortgage payment every 2 weeks, instead of once per month. This method helps you repay your loan faster because it equates to one extra monthly payment every year. Instead of paying 12 monthly payments, you end up paying 13.
Sell When The Time Is Right
As explained above, the market can affect how much equity you have in the home. Selling your home when the market is good and home values are high may give you more equity than selling when the market is bad and home values have fallen.
While you can’t control what the market does, you can keep track of it and follow market trends. One easy way to do that is with the Rocket HomesSM trends report. Among several important pieces of information, the report will tell you the median sold price for your location and if it’s a buyer’s or seller’s market, a key indication of whether you should sell your home or wait.
Make Your Home More Valuable
There are several ways to add value to your home, some more costly than others. Simple updates may include applying a new coat of paint, enhancing curb appeal with landscaping or updating furnishings with new hardware. More involved and costly updates may include renovating your kitchen, remodeling your bathroom or adding more livable space by renovating your basement or installing a four-seasons room.
Before you spend a ton of money updating your home, make sure these changes will actually bring you a return on investment. You don’t want to spend more money on the project than the value it will add to your home.
How To Leverage Home Equity
The equity you have in your home is your money. However, it can be difficult to access as it’s tied up in your home. Here are a few ways to leverage it.
Home Equity Loan
A home equity loan allows you to borrow against the equity in your home, and you receive the money in one lump sum payment.
This loan is equivalent to a second mortgage, using your home as collateral. If you default on the loan, you could lose your home.
The loan adds to your monthly debt. With this loan, you’ll have your mortgage payment and a home equity loan payment.
Home Equity Line Of Credit (HELOC)
Like the home equity loan, the HELOC allows you to borrow against the equity in your home. However, with a HELOC, you receive the money through a revolving line of credit. Similar to a credit card, there is a maximum amount you can borrow and your balance is carried over month to month.
As with the home equity loan, you’ll add to your monthly debt. While your balance is carried over month to month, you’ll still have a minimum monthly payment. Something to consider is that this payment can fluctuate since you’re only charged interest on your balance, which may be different each month.
As the name suggests, a cash-out refinance is a refinance option that allows you to convert some of your equity into cash.
Unlike the home equity loan or HELOC, a cash-out refinance replaces your mortgage, which updates your monthly payment. That means you won’t have an additional bill; you’ll just have a different mortgage payment than before.
A Home Equity Conversion Mortgage (HECM), also known as a reverse mortgage, allows homeowners 62 and older to access the equity in their home to first pay off their existing mortgage, then use the remaining money however they want. Along with allowing access to home equity, the loan also eliminates monthly mortgage payments, freeing up more money each month. Reverse mortgage borrowers are still responsible for paying their homeowners insurance and property taxes.
When you sell your home, you’ll get all of the equity you have in the home (minus any fees, like agent commission), which could make a sizeable down payment on your next home. This can allow you to purchase a more expensive home or provide a large down payment – or both.
For example, you sell your home for $250,000. You pay off your $150,000 mortgage balance, leaving you with $100,000. You purchase a new home for $300,000. After paying the fees to sell your home and purchase a new home with a new mortgage, you’re able to put down $75,000, or 25%, on your new home.
When selling your home, consider capital gains tax. Currently, you do not have to pay taxes on any home sale profit below $200,000 if you’re single and $500,000 if you’re married and filing a joint return. However, you must have lived in the home for at least 2 years.
Home Equity Practices To Watch Out For
Not all lenders are the same and, unfortunately, some can be deceptive, unfair and exploitive. When looking for a home equity lender, keep an eye out for these predatory lending practices.
Loan flipping is when a lender refinances a loan at a loss to the borrower. While it may seem like the homeowner is getting money from their equity, the amount is usually lost to higher interest rates, a longer loan term, high fees or prepayment penalties.
To avoid this practice, only work with well-known banks or lenders that you’ve researched and contacted for more information. If unsolicited lenders reach out to you, ignore them. Review all documents, ask questions, request an explanation of all fees and, if you’re unsure, have a trusted family member, friend or real estate attorney review the documents.
Insurance packing happens when a lender adds insurance clauses to your contract, then adds the cost onto the loan amount or fees paid. This addition often goes unnoticed by the borrower. Other times, lenders will coerce borrowers into buying unnecessary insurance and add it to the loan amount.
Carefully reading your contract or having a real estate attorney review the document will help you avoid insurance packing. If you feel any pressure or intimidation to sign the contract or add insurance, do not move forward with the transaction.
Bait And Switch
True to its name, the bait and switch practice first entices, or “baits,” borrowers with an almost-too-good-to-be-true offer, then when the borrower asks about it, the lender says it’s no longer available or they don’t qualify for the deal and “switches” to a different product or offer that’s often more expensive. In the lending world, this is often seen with extremely low interest rates, that a very small percentage of the population would actually qualify for.
The first thing to remember is if something seems too good to be true, it probably is. The next thing to remember is that your mortgage rate is determined by factors like your credit score, loan-to-value ratio and the type of loan you get. When considering that low rate, think about where you stand financially. If, for example, you have a lower credit score or only the minimum down payment, chances are you won’t qualify for the extremely low rate the lender is advertising.
A balloon payment loan starts with low monthly payments for a specified amount of time, then at the end of that period, the rest of the loan is due in one, often large, lump sum. If a homeowner cannot afford the payment at that time, they may be forced to find a way to refinance the house, sell the house or default on the loan and enter foreclosure. Balloon payments are especially dangerous in a bad market when housing prices are dropping.
Predatory lenders like these types of loans because they can be easy to sell since the initial monthly payments are low and often lead to repeat business since those who can’t afford the payment at the end may be forced to refinance.
The best way to avoid balloon payments is to choose another lending option. If you’re currently in a balloon payment mortgage, you may want to consider refinancing, especially if rates are low.
Predatory lenders may charge you additional, excessive fees or higher rates for refinancing your loan. They may try to hide them in the contract or they may use your credit score or financial standing to justify these fees.
To avoid this practice, shop around to get a better idea of mortgage rates and fees and to spot any significant red flags. Review your credit score and credit report to get a better understanding of where you stand as a borrower.
How COVID-19 Has Impacted Home Equity
In an effort to stimulate the economy after the fallout of COVID-19, the Fed cut mortgage rates to historic lows. Lower rates mean less-expensive mortgages – for both home purchases and refinances.
COVID-19 has also influenced people to move out of the city or search for homes with more space or ones that feature a home office.
This new desire to move and the ability to get a mortgage with a better rate has caused a boom in the housing market. This increase in home buying has created seller’s markets in many areas across the U.S., and there is a higher demand for homes than there is a supply. This has driven up home prices, thus increasing the equity for many homeowners.
Is It Time To Use Your Equity?
With low rates and high home values, it may be a good time to leverage your home equity. But whether you’re thinking of doing so through selling your home, taking out a loan or refinancing, remember that all of these actions come with additional fees.
While the timing seems right, from a market point of view, it might not be the right time for you based on your finances or your goals. Take time to consider the pros and cons unique to your situation. Your equity could help you purchase a new home, make improvements to your current home, consolidate debt or have additional money for other needs. However, it’s important to remember that it will take time to regain the equity you’ve used.
If you’ve considered all of your options and you’re ready to gain access to your home equity, consider a cash-out refinance with Rocket Mortgage®.