See the article from The Balance…
Home equity is a homeowner’s interest in a home. It can increase over time if the property value increases or you pay down the mortgage loan balance.
To state it another way, home equity is the portion of your property that you truly “own.” If you borrowed money to purchase a home, your lender has an interest in the property until you pay off the loan, although you’re still considered the homeowner.
Important: Home equity is typically a homeowner’s most valuable asset. That asset can be used later in life, so it’s important to understand how it works and how to use it wisely.
Home Equity Example
The easiest way to understand equity is to start with a home’s current value and subtract the amount owed on any mortgages or other liens.1 Those mortgages might be purchase loans used to buy the house or second mortgages that were taken out later.
Assume you purchased a house for $200,000, made a 20% down payment, and obtained a loan to cover the remaining $160,000. In this example, your home equity interest is 20% of the property’s value: The property is worth $200,000 and you contributed $40,000 — or 20% of the purchase price. Although you’re considered the property owner, you only officially “own” $40,000 worth of it.
Your lender doesn’t own any portion of the property. Technically, you own everything, but the house is being used as collateral for your loan. Your lender secures its interest by getting a lien on the property.
Now, assume your home’s value doubles. If it’s worth $400,000 and you still only owe $160,000, you have a 60% equity stake. You can calculate that by dividing the loan balance by the market value and subtracting the result from one (Google, or any spreadsheet, will calculate this if you use 1 – (160000/400000), and then convert the decimal to a percentage). Your loan balance remains the same, but your home equity increases.
As you can see, it’s to your benefit to build up more home equity. Here’s how to increase your equity:
Loan repayment: As you pay down your loan balance, your equity increases. Most home loans are standard amortizing loans with equal monthly payments that go toward both your interest and principal. Over time, the amount that goes toward principal repayment increases — so you build equity at an increasing rate each year.
Price appreciation: You can also build equity without any effort on your part. When your home increases in value (because of improvement projects or a healthy real estate market), your equity grows.
Using Home Equity
Equity is an asset, so it makes up a portion of your total net worth. You can take partial or lump-sum withdrawals out of your equity at some point if you need to, or you may pass all the wealth on to your heirs. There are several ways to put that asset to work.
Buy your next home: You probably won’t live in the same house forever. If and when you move, you can put the proceeds from the sale of your current home toward the purchase of your next home. If you still owe money on any mortgages, you won’t get to use all of the money from your buyer, but you’ll be able to use your equity.
Borrow against the equity: You can also get cash and use it to fund just about anything with a home equity loan (also known as a second mortgage). However, it’s wise to put that money toward a long-term investment in your future. That’s why paying your current expenses with a home equity loan is risky.
Fund retirement: You can choose instead to spend down your equity in your golden years using a reverse mortgage. These loans provide income to retirees and don’t require monthly payments. The loan is repaid when the homeowner leaves the house. However, these loans are complicated and can create problems for homeowners and heirs.
Two Types of Home Equity Loans
Home equity loans are tempting because you have access to a large pool of money — often at fairly low interest rates. They’re also relatively easy to qualify for since the loans are secured by real estate. Before taking funds from your home equity, look closely at how these loans work so that you fully understand the possible benefits and risks.
A home equity loan is a lump-sum loan. You get all of the money at once and repay in flat monthly installments throughout the life of the loan, generally five to 15 years. You’ll have to pay interest on the full amount, but these types of loans may still be a good choice when you’re considering a large, one-time cash outlay. Examples of this are paying for a full rehab of your home; consolidating higher-interest debts, such as credit cards and personal loans; or buying a vacation getaway. Your interest rate is usually fixed as well, so there will be no surprising hikes later, but note that you’ll likely have to pay closing costs and fees on your loan.
A home equity line of credit (HELOC) allows you to pull funds out as necessary, and you pay interest only on what you borrow. Similar to a credit card, you can withdraw the amount you need during the “draw period” (as long as your line of credit remains open). For this reason, HELOCs are often useful for expenditures that can be spread out over a period of years, like minor home renovations, college tuition payments, and assisting family members who may temporarily be down on their luck.
During the draw period, you have to make modest payments on your debt. After a certain number of years (10 years, for example), the draw period ends, and you enter a repayment period in which you pay off all of the debt more aggressively, possibly including a hefty balloon payment at the end. HELOCs usually feature a variable interest rate too, which means you could end up having to pay back much more than you budgeted for over the 15- to 20-year life of the loan.
The major issue with either type of equity loan is that your home serves as the loan collateral. If you’re unable to repay for any reason, your lender can take your house in foreclosure and sell the property to recover its investment. This means you and your family will need to find other accommodations — probably at an inconvenient time — and your home probably won’t sell for top dollar. For this reason, it’s smart to avoid the temptation to use your windfall to splurge on exotic vacations, designer clothes, big-screen TVs, luxury cars, or anything else that doesn’t add value to your home. A safer move is to sock away cash for those treats, or even spread out the cost using a credit card with a 0% intro APR offer.
How to Qualify
Before you start shopping around for lenders and loan terms, check your credit score. To obtain a home equity loan, you’ll need a credit score of at least 680 or so.7 Higher is better. If you can’t meet the bar as far as your credit score is concerned, you probably won’t be able to qualify for either type of loan until you repair your credit score.
You must also demonstrate to the lender your ability to repay the loan. This means providing your credit history and documentation of your household income, expenses and debts, and any other amounts you’re obliged to pay.8
Your property’s loan-to-value or LTV ratio is another factor lenders look at when determining whether you qualify for a home equity loan or HELOC. It’s probably best to keep at least 20% equity in your property, which translates to a minimum LTV of 80%, but some lenders allow bigger loans.