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What is Home Equity and Why is it Important?

by Sally Kelsies

Homeownership is very rewarding. Not only do you get a place that you can call home, but you get to take advantage of many financial benefits that come with it. For instance, there are several home and mortgage related expenses that you can write off as tax deductions. One other financial benefit is something called equity – something that can be a very powerful tool. Here, we will answer the question of what is home equity, as well as some of the things you can do with it. We will also discuss why it is important.

What is Home Equity?

Equity is a very common term, however, many people may not know what it really means. In its simplest form, equity represents the value of ownership in something. This concept can be applied to corporations when analyzing their balance sheets, or it can be applied to personal items like a car or home. For instance, the amount of shareholder’s equity in a company represents the aggregate amount of the company shareholders own. It is the corporation’s owners’ residual claim on assets after debts have been paid. It can be calculated by subtracting total liabilities from total assets.

When applied to a automobile or house, equity is calculated as the money value of something in excess of claims or liens against it. A claim or lien can include things such as an auto loan or your mortgage. To break this down further, imagine you own a car with a market value of $30,000. When you were wondering how to buy the car, you decided to take out an auto loan. The outstanding balance of your loan is $15,000. This means that the amount of equity you have in your car is $15,000.

Let’s look at this example applied to a home. You took out a $450,000 mortgage to pay for a home that is currently worth $500,000. You paid the loan down and the current balance is $200,000. This means that you have $300,000 worth of equity in your house.

In both of these instances, you have positive equity. This is not always the case.

What is Negative Equity?

Having negative equity in something is not good. If you take the value of something, like a house or car, and take the difference between its value and how much you own on any outstanding loans used to purchase this item, and this number is negative, you have negative equity.

Let’s look at an example of this. Imagine you buy a $50,000 car with a loan. The current value of the car is $35,000 due to deprecation, however the outstanding balance of your loan is $40,000. By taking the difference, you will see that the amount of equity you have in this car is -$5,000. If you sold the car, you would not have enough money to cover the balance of your loan. Having negative equity in something is known as being upside-down in it. Another term is being underwater.

The concept of being upside-down or underwater can be applied to anything really, including your home.

How to Use Your Home Equity

Equity is a very important concept to be able to understand, especially when applied to your house. Homes usually hold their value, or appreciate depending on economic factors. This means that the amount of equity you have in your home will not be constant.

As your home or the real property (like a car) tied to your loan increases in value, so will the amount of equity you have in it. What does this look like? Pretend you buy a home for $250,000 and take out a mortgage for $250,000. You pay down the loan $100,000. If the market value of your house stays constant at $250,000, then you have $100,000 worth of equity in your home. (Market value of $250,000, less outstanding loan balance of $150,000, equals $100,000.)

However, if the market value of your house increases to $300,000, you now have $150,000 worth of equity in your home. ($300,000 market value, less $150,000 outstanding loan balance, equals $150,000 worth of equity.)

Now that you know more about this concept, let’s focus how you can use it to your advantage.

Buying a New Home

Are you looking to sell your current home to buy a new one? Well, the amount of equity you have in your current house could be used as a down payment for your new one! If you decide to do this, note that the timing of the sale of your old house and the purchase of your new house will be big factors.

So, how can you use your home equity to buy a new home? Well, let’s say you are selling a home for $400,000. Over the time you have spent living there, you have paid off half the mortgage and now have $200,000 worth of equity in your home. If you sell your home for the amount you purchased it for ($400,000), you should get your $200,000 back. There are closing costs and other various fees involved in this process, so you may get a little more. If your house appreciated, you may get more money than you paid down your loan with.

You can use this money as a down payment for a new home if you are upgrading. Depending on the amount of home equity you have in your old house, maybe you will use some of the funds for the down payment, and the rest for some much needed renovations on the new place.

If you have more equity in your current home then the price of the home you are looking to purchase, you can buy it outright! Although you can do this, it might not be the best thing to do. Have a discussion with your accountant for more details.

Using Home Equity for Borrowing

Another popular way of using the equity you have in your home is by borrowing against it. There are several different methods of doing this. They include a home equity loan, a home equity line of credit (HELOC), or a cash out refinance.

There are many reasons why you may want to take some of the equity out of your home and put it to use. Maybe you want to make renovations to your existing home, or put in a pool. Not only will these be great features to live with, but they can also increase the market value of your house.

Home Equity Loan

A home equity loan, also known as a second mortgage, is a way you can borrow against the amount of equity you have build in your home. Home equity loans enable homeowners to borrow against the equity they have in their homes.

The amount that you can get approved for is based on the difference between the home’s current value and the amount of you own on your mortgage. This should sound familiar to you – it is the same calculation for your home equity. This is where the name comes from. The equity in the home serves as collateral for the lender. Most lenders will only approve you for a certain percentage of the equity you have in your home, for instance 80%. Also, the interest rate on a home equity loan is usually a fixed amount.

Home Equity Line of Credit

A home equity line of credit, or HELOC, is very similar to a home equity loan. However, instead of being a loan, it is a revolving line of credit. This means, if you get approved for a $50,000 HELOC, you don’t need to use the entire amount. Think of this financial product similar to a credit card. If you get a $50,000 HELOC, you can use $10,000, and pay it back. Or you can draw down this line of credit as much as you need. You only need to pay back what you borrow.

Home equity lines of credit can be more flexible than a home equity loan. For instance, there is something called an interest only HELOC. These are similar to a normal HELOC, instead of having to pay back principal and interest, you just pay back interest. For instance, let us assume you use up your entire HELOC. For a set period of time, for example 10 years, you may only need to pay back the interest due on this loan. After this 10 years is up, you then have another set period of time to repay the balance. This can be a useful feature, however remember that if you are only paying back the interest, you won’t be able to take any more funds out of your HELOC if you use the entire balance up.

Cash Out Refinance

One of the last ways you can use the equity you build in your house is by doing a cash out refinance. Unlike with a home equity loan or HELOC, a cash out refinance is not just an additional loan you take on. Instead, you are getting a completely new mortgage. It is almost like refinancing a mortgage. It differs from refinancing a mortgage because you are actually getting a new mortgage for more than the amount you have outstanding on your loan.

Say you owe $100,000 on your mortgage. You can get a new mortgage for $150,000, and then take the cash to do something with. You will then repay the new $150,000 mortgage normally. The amount of additional money you can get in a cash out refinance depends on the amount of equity you have in your home.

Before Borrowing Against Your Home

Borrowing against your home can be a great financial decision. However, it does come with risks. For instance, in all of these examples you are using your home as collateral. If you are unable to make a payment on your home equity loan, HELOC, or refinanced mortgage, you could lose your home. Having some amount of equity in your home is a good thing, so always be responsible with the amount you use.

Also, the amount of equity you have in your home can change due to the economic environment. If you purchase your home when the market is hot, the value of your home may come down. This will affect the equity equation and can leave you underwater in your mortgage.

If you have any questions about which borrowing option against your home equity is right for you, talk to an accountant or mortgage professional.

What is Home Equity – Summary

After this, you should be able to answer the question of what is home equity. To review, home equity or equity in anything is determined by subtracting any outstanding loans used to purchase this item from its current market value. Home equity is very useful, and can help you purchase a new home, put in a pool, or renovate your kitchen.

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