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Home Equity Explained: What It Means And How To Build It

Michelle Giorlando9-Minute Read
February 14, 2022

Home equity is a concept that’s talked about a lot during the homeownership journey. Have you made a mortgage payment? Congratulations – you’re building equity in your home!

Let’s look at what home equity is, what goes into calculating it, how to build it, and how you can use your home equity to your advantage.

Home Equity: Defined

At its simplest, home equity is the amount of money you’ve paid into your home after you’ve subtracted your mortgage balance and any liens on your property from the home’s current market value.

For example, if your home is worth $300,000 and you still owe $175,000 on your mortgage, then you have $125,000 worth of equity in your home.

Note that it’s not a dollar-to-dollar amount – several factors influence your home equity amount.

What Factors Go Into Calculating Home Equity?

There are three main factors that go into calculating home equity: down payment, loan balance, and the home’s market value.  

Down Payment

The first factor in home equity is the down payment amount. The down payment is a percentage of the purchase price paid upfront at closing. This reduces the amount of the mortgage and affects how much equity you start with. The more you put down, the more equity you’ll start with.

For example, say you bought that $300,000 house. If you put down 10% of the purchase price ($30,000), you’ll start out with 10% home equity.

Down payment amounts vary, but most loans require a down payment. It’s a common misconception that you must put down 20% of the home’s purchase price. Putting down less than 20% simply means you may have to carry mortgage insurance until you reach 20% equity in your home.

Conventional mortgage loans require private mortgage insurance (PMI) for loans with less than 20% down. There are a few different ways you can pay your PMI:

  • An additional monthly payment you’ll make until you reach that 20% equity, also known as borrower-paid mortgage insurance, or BPMI.
  • Lender-paid mortgage insurance (LPMI), where your mortgage lender pays your insurance premium, and in exchange, you take a slightly higher interest rate.

Government-backed loans like FHA loans also require mortgage insurance, which is paid as a mortgage insurance premium (MIP). MIP is made up of two components:

  • An upfront premium (UFMIP) payment is made at closing. This rate is currently 1.75% of the total mortgage amount. For our $300,000 example with 10% down, the initial loan amount would be $270,000, meaning the UFMIP would be calculated as 270,000 x .0175, coming out to $4,725.
  • An annual premium of 0.85% of the total loan amount is broken up over 12 monthly payments. For the loan of $270,000, this calculates as 270,000 x .0085 ÷ 12, equaling $191.25 per month.

Other aspects will affect that MIP amount. If you put down less than 10% on your FHA loan, you’ll pay MIP for the life of the loan. But, if you put down 10% or more, you’ll only pay MIP for 11 years.

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Loan Balance

The second factor that goes into calculating your home equity is your loan balance. This is inversely proportional to your home equity: the lower your loan balance is, the higher the amount of your home equity is!

Let’s look at that example where your home is worth $300,000 and you still owe $175,000 on your home loan. You have $125,000 worth of equity in your home. Now let’s say you have paid off even more of that mortgage, and you now owe $100,000 on it. This means you now have $200,000 in home equity.

Market Value

The third factor that affects your home equity is the market value of your home. This is the amount of money your home is worth in the current housing market. If your home rises in value, you gain equity. If it falls in value, you lose equity.

Using our $300,000 home example, let’s say the housing market around you is thriving, and your home is now worth $350,000. This means you’ve gained $50,000 in equity simply from the value of the home in this housing market!

What Does It Mean To Build Equity?

Building equity is how we refer to adding your own ownership to your home. While you won’t be able to control the housing market, there are several steps you can take to increase your equity.

How Can I Build Equity In My Home?

The main ways you can build equity in your home involve your down payment and your loan balance. Each way involves time and money – most are achieved over time and cost money in one way or another.

Make A Larger Down Payment

Putting more money down when you’re buying a house starts you off with more equity. It’s especially helpful to consider this if you’ll be paying mortgage insurance otherwise. The more money you’re able to put down initially means a shorter time you’ll pay those mortgage insurance premiums. Putting down at least 20% on your conventional mortgage means you’ll avoid PMI altogether.

Pay Your Mortgage Off Early

When you pay off your mortgage entirely, you have 100% equity in your home. By paying your loan off earlier than scheduled, you’ll enjoy that 100% equity sooner! An excellent side effect of paying your mortgage off early is that you’ll also save thousands of dollars in interest payments. Check with your lender to ensure you won’t get charged a prepayment penalty fee.

There are two common ways you can pay off your loan early in an incremental approach: increasing your monthly payments and making biweekly payments.

Increase Your Monthly Payment

Each mortgage payment you make goes to paying down your principal balance and your interest. If you’re able to pay more each month, you can apply that extra amount to your principal balance. The quicker you pay it down, the less you’ll pay in interest, since interest is a percentage of the principal balance. Any amount helps! Let your lender know to apply your extra funds to your principal balance, and not as a prepayment for the next month’s interest payment.

Make Biweekly Payments

Making biweekly mortgage payments allows you to make an entire extra mortgage payment a year! This payment method entails making half a mortgage payment every 2 weeks, instead of a full payment once a month. Because there are 52 weeks in a year, you’ll make 26 half-payments, which translates to 13 full payments.

Making biweekly payments allows you to pay down your principal balance faster. This allows you to build equity more quickly and pay less in interest.

Increase The Home’s Value

One way of building equity in your home is to increase your home’s value through renovations. There are renovations to consider at every price point, whether it’s sprucing up landscaping or remodeling the kitchen.

Not every renovation is created equal (sorry, swimming pools). Make sure the reno you’re considering adds value:

  • Bathroom remodels can be as simple as removing dated wallpaper, hardware and fixtures, all the way up to a complete overhaul.
  • A remodeled kitchen can bring in a lot more when you sell your home. Consider upgrading your appliances and installing new countertops.
  • Refreshing your landscaping adds curb appeal, which can factor into your home’s value when refinancing or selling your home

Just keep in mind, increasing the value of your home with a renovation could impact your home insurance Check with your agent before completing any major improvements, like building an addition or finishing a basement.

Options To Leverage The Equity In Your Home

Now that you’ve got some equity in your home, what can you do with it? Though it’s technically your money, it’s tied up in your house. You can leverage that equity in a few different ways to access your money.

Home Equity Loan

You can use a home equity loan to tap into your home’s equity. It allows you to use the equity you’ve built up in your home as collateral for a lump sum of money. You then repay the loan in monthly payments, just like a primary mortgage. If you’ve got a primary mortgage, then you’ll make this payment in addition to your monthly primary mortgage payment. Home equity loans are often called second mortgages for this reason.

There are many benefits of home equity loans:

  • Interest rates are fixed and tend to be lower than other loan types.
  • You’ll receive your money in a lump sum, allowing you to access it right away.
  • There are no restrictions on how you can use your money.
  • These loans are easier to qualify for than other types.
  • Monthly payments are a fixed amount.

As with any loan, it’s important to recognize your budget limits – remember, you’ll need to make payments on both your primary loan and your home equity loan each month. If you sell your home before your home equity loan is paid off, you’ll pay the balance at closing.

Rocket Mortgage® is now offering The Home Equity Loan, which is available for primary and secondary homes.

Home Equity Line Of Credit (HELOC)

With a home equity line of credit (HELOC), you use the equity you’ve built up in your home as collateral to access funds. However, instead of a lump sum, you access it as a revolving line of credit, like a credit card. Your balance carries over month to month, and there’s a maximum on how much you can borrow.

There’s a minimum amount you’ll need to pay each month, and you’re charged interest only on your balance, meaning your HELOC monthly payment will fluctuate. Another factor that affects your payment is the interest rate. HELOCs have an adjustable rate, meaning the rate increases or decreases based on the market.

Note that Rocket Mortgage® currently does not offer HELOCs.

Cash-Out Refinance

Yet another way to use your home equity is with a cash-out refinance. Unlike home equity loans and HELOCs, a cash-out refinance replaces your primary mortgage with a brand-new mortgage, so you’ll only have one monthly payment.

With a cash-out refinance, you take out a loan for more than you currently owe and get that extra amount in cash after closing. You use some of the equity you’ve built and add it on to a new mortgage.

For example, say you bought your home for $300,000 and have paid off $100,000 so far. You have $200,000 left on your original mortgage. You want to do home renovations for $50,000. With a cash-out refinance, your new mortgage would be for $250,000. $200,000 is what you still owe on your home, and that other $50,000 will be given to you by your lender 3 – 5 days after closing.

Get approved to refinance.

See expert-recommended refinance options and customize them to fit your budget.

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Reverse Mortgage

A reverse mortgage, or home equity conversion mortgage (HECM), is for homeowners aged 62 or older. A HECM allows you to use your equity to pay off the remainder of your primary loan, and then use the rest of the money however you’d like, for living expenses, building up savings, paying off debt, etc. Reverse mortgages were designed to help folks of retirement age access their funds and eliminate a monthly payment.

While having a traditional loan means you make monthly payments to pay down your loan, with a reverse mortgage, you receive payments from your lender. The payments you receive are from that excess equity you have. It’s important to remember that the payments you receive are all from your own money. It’s simply a different way to receive funds from your equity.

Another key factor to remember is that you still pay your property taxes and homeowners insurance.

Note that Rocket Mortgage® currently does not offer reverse mortgages.

FAQs About Home Equity

Home equity is a complicated subject, both in how it’s calculated and how you can use it.

When are home equity loans or HELOCs a good idea?

Both home equity loans and HELOCs are good to consider when you want to access the funds tied up in your home’s equity and can financially handle a second monthly payment, since both loan types are designed to exist in addition to your primary mortgage loan.

Consider a home equity loan if you want to access your equity in a lump sum after closing, and you want the steady nature of a fixed interest rate and a consistent monthly payment.

Consider a HELOC if you’re willing to use your equity as a line of credit and want to make payments much like a credit card. HELOCs offer more flexibility, allowing you to draw on your funds over a longer period for ongoing maintenance or renovations.

Note that Rocket Mortgage® currently does not offer HELOCs.

What happens to my home equity when I sell my house?

When you sell your home, you’ll get all the equity you’ve built! You’ll have to subtract any fees, like agent’s commission, but everything else is yours. If you’re looking to buy a new home, this equity can help make a nice down payment, which helps you save money on interest with your new mortgage.

How has COVID-19 impacted home equity?

COVID-19 has had a big effect on home equity. In 2020, the Fed decided to stimulate the economy by lowering interest rates, meaning both purchase and refinance loans are much less expensive. With many folks working from home, the housing market has been affected in other ways. Specific needs such as home offices are in demand.

The ability to work remotely has also freed many people from geographic constraints. More home buyers are looking to move to areas with lower cost of living or more space. There’s a higher demand for homes than are for sale, so home prices are rising. This equals equity for homeowners!

The Bottom Line: Is It Time To Use Your Equity?

Choosing to use 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 home equity loan, refinancing, or even selling your home. The most important factor is to find what works best for your goals and budget.

If you decide you’re in a position to make your equity work for you, consider a cash-out refinance with Rocket Mortgage.

Get approved to refinance.

See expert-recommended refinance options and customize them to fit your budget.

NMLS #3030

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Michelle Giorlando

Michelle Giorlando is a freelance writer who lives in metro Detroit. When she's not writing about homeownership, finances, and mortgages, she enjoys performing improv, gardening, and befriending the wildlife in her yard.