Home equity is one of the most important basic concepts for homeowners and future homebuyers to understand. Your home equity can determine your ability to borrow money cheaply, avoid paying excessive borrowing costs on a mortgage, and can even let you use your home for a stream of retirement income. We'll look at the basics of what home equity is, how it's calculated, and why having equity in your home is so important.
What is home equity?
The short answer is that home equity is the portion of your property that you own. In simple terms, home equity is the difference between your home's current market value and the amount of money you owe on it. If you own a home worth $400,000 and have a $300,000 mortgage balance, you have $100,000 in equity in the home after closing, assuming you didn't dramatically overpay or underpay for it.
Home equity doesn't always have to be a positive number. It can be negative if you owe more on your home than it's worth. This unfortunate situation is often referred to as being "underwater" on your mortgage.
There are two ways your home equity can increase. You can pay down some or all of your mortgage balance or other home-related debt. Or your home's market value can increase, either naturally over time, or by you making value-adding improvements to it.
Calculating home equity
First of all, calculating home equity isn't an exact science. The general method used by most lenders, accountants, and other professionals is to take the appraised value of your home and subtract the outstanding balance on your mortgage.
As an example, if an appraiser determines a home you own is worth $350,000 and you have an outstanding mortgage balance of $220,000, your equity in the home is $130,000.
Not surprisingly, home equity fluctuates over time. As the market value of your home changes and your unpaid mortgage balance declines over time, the amount of equity you'll have in the property will change. Continuing the example in the last paragraph, if you were to pay down $10,000 of the mortgage balance over the next year by making your mortgage payment on time every month and the home's market value increases by $15,000, you can expect your home equity to rise by roughly $25,000 to $155,000.
However, here's why this isn't terribly precise. First, appraisals are done according to certain common methodologies, but there's a pretty large component of opinion in the process as well.
In other words, one appraiser might consider your roof to be in reasonably good condition, while another might think it needs to be replaced within a year or two. One might add $20,000 in value for a two-car garage, while another may only add $15,000. If you were to hire five appraisers to determine the value of your property, it wouldn't be shocking to get five different values -- although they should be in the same ballpark.
Second, the unpaid principal balance on your mortgage isn't necessarily the actual amount you would need to pay it off. For one thing, you'd likely have to pay whatever interest has accumulated since the last payment was made, and some loans (especially with investment properties) have prepayment penalties.
Finally, don't forget about sales commissions and other closing costs you'd have to pay if you sold. And there's absolutely no guarantee your home would sell for its full appraised value -- unless your market is particularly strong, it's quite common for homes to sell for a bit of a discount to what an appraiser thinks they're worth.
The bottom line is that home equity is a financial concept important for a few reasons, which we'll get to in a bit. But many homeowners think of it as a precise measurement of how much money they would walk away with if they decided to sell their homes, and it's important to realize that's not exactly true.
Why home equity is important
There are a few reasons why home equity is such an important concept for homeowners and future homebuyers to understand and why having home equity can be financially beneficial.
Taking cash out of your property
For one thing, homeowners can potentially tap into their equity to help pay for large purchases, such as renovations or college tuition for children, or for debt consolidation purposes to reduce or eliminate credit card debt. Homeowners with sufficient equity in their homes may be able to refinance their mortgages for a higher amount and walk away with cash at closing, known as a cash-out refinance. Or, homeowners can obtain a home equity loan (also known as a second mortgage) or home equity line of credit (HELOC) to access their equity without having to refinance their existing loan.
Borrowing money against your home's equity through one of these types of home loans is typically much cheaper than obtaining a personal loan or using a credit card. Since the debt is secured by your home, it's far less risky in the eyes of a bank.
It's worth mentioning that home equity for the purpose of refinancing or obtaining a home equity loan or line of credit is determined by an appraisal. To be perfectly clear, an appraisal doesn't necessarily tell you how much your property would sell for on the open market -- it's simply a trained professional's opinion of its value.
Calculating your sale proceeds
Second, while home equity isn't an exact science, as discussed in the previous section, it can be useful to know roughly how much cash you can expect to walk away with if you were to sell your home at a certain price. For example, if you're planning to move and want to put a 20% down payment on your next home, knowing your home equity can help you determine how much money you'll have available to do so.
Avoiding PMI and saving money on a mortgage
Finally, when you buy a home, your equity can determine whether you have to pay private mortgage insurance (PMI). Specifically, if you put less than 20% down when you buy, you'll probably have to pay for PMI with your mortgage's monthly payment. But if your initial equity is equal to or greater than 20%, you can probably avoid this expense.
Beyond PMI, a larger down payment (more equity) can result in you receiving a lower interest rate on your loan. The short explanation is that borrowers with more equity have a higher financial interest in the property and therefore represent less of a risk to lenders.
Obtaining a reverse mortgage
If you have sufficient equity in your home and you're at least 62 years old, you may be able to obtain a reverse mortgage to help fund your living expenses in retirement.
You can read our guide to reverse mortgages, but the general idea is that unlike a traditional mortgage where you make payments to a lender, a reverse mortgage provides payments to you, either in a lump sum or as a series of payments. You typically don't have to make any payments on a reverse mortgage until you (or your heirs) sell your home.
The Millionacres bottom line on home equity
Home equity is an important concept for homeowners to learn. It has several major financial implications, both long- and short-term in nature. While it isn't an exact science, it's important to know how home equity is calculated and to assess where you stand every so often.