Home Equity: What is it and How to Use it
Home equity refers to the homeowner’s stake, one that can increase or decrease over time, depending on the mortgage payments and the home’s value.
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The higher your home equity is, the better, as it gives you more flexibility when applying for future loans and means you technically own a greater share of your own home.
Home Equity: Who Owns the House?
Home equity causes some confusion and misunderstandings regarding who actually owns the home. If you take out a mortgage with an 80% loan, then technically you own just 20% of your home. However, this doesn’t necessarily mean that the bank owns 80% and therefore has a greater share than you do.
Contractually speaking, the house is yours. You can’t lend against anymore equity than you have, and you won’t have complete legal ownership until you’ve paid every cent, but for as long as that contract remains active, the bank cannot foreclosure.
If, however, you are found to be in breach of contract, none of that matters and the bank may obtain their share via a repossession. At this point, your share no longer matters. The lender will claim the house and sell it to recover their costs.
This process may be initiated if you do any of the following:
Fail to Make Mortgage Payments
Missed payments are the most common reason for a foreclosure. Mortgage payments are over $1,000 on average, a large sum of money to pay every single month. It only takes an unexpected bill, a missed paycheck or an employment issue for that payment to be missed, and once that happens, the clock starts ticking toward foreclosure.
The bank gives you a home loan on the basis that you make a minimum payment every month. If you don’t, you default on the agreement and they may seek alternative ways of recovering their funds.
You Don’t Pay Taxes or Insurance
Your monthly mortgage payments include insurance and taxes. These are paid every year, but they are added to your monthly mortgage payments and then held in Escrow before being paid by the lender.
Failing to cover these payments will cause issues for you and the lender and may lead to a foreclosure. If you don’t pay taxes, for instance, a lien may be placed against your property, and this takes priority over the lender’s claim.
As for homeowner’s insurance, failure to pay means the house is at risk. If there is a fire, flood or other serious damage, and the premiums are not maintained, the insurance company will refuse to cover the cost, leaving you and the lender out of pocket.
To account for this, the lender will purchase something known as “lender-placed” insurance, and then expect you to cover the costs. If you don’t, they may initiate the foreclosure process to reclaim the money and settle the debt once and for all.
To learn more about this process, see our guide to repossessions and foreclosures.
The Agreement is Violated
There are other ways you can violate a mortgage agreement. In these cases, however, it’s rare for the lender to initiate a foreclosure and they often work with the homeowner to set things right.
For instance, a mortgage agreement often states that the property needs to be properly maintained. It only makes sense—until you repay your loan in full, the bank has a sizeable share in the house and needs it to maintain its value in case of foreclosure. If you run it to the ground, you decrease the value and their chances of getting a decent return are reduced.
You will also face issues if you transfer the title to a different owner. Home loans often include a clause that warns against such a transfer taking place, insisting that the balance must be paid in full if the house is transferred to a new owner. This can happen following a sale or a simple deed transfer—in any case, the balance must be covered.
Understanding Home Equity
The great thing about home equity is that the amount you own increases along with the property’s value, but the amount “owned” by the lender remains the same as it’s based on the initial cash value.
For example, let’s assume that you bought a house valued at $100,000 with a 10% down payment. Assuming there are no liens against the home, you own a 10% equity share on day 1, while the lender “owns” a 90% share.
Now, let’s say that the home suddenly increases in value and somehow moves from a valuation of $100,000 to one of $200,000. You didn’t borrow or pay a penny more and you still need to repay the initial $90,000 principal, but the bank’s share has just dropped from 90% to 45%, which means your share has gone from 10% to 55%.
This sudden equity increase has a number of benefits. Firstly, it gives you more options when you eventually sell the house. You can pay the mortgage debt in full using money from the sale, and then have enough cash leftover to make a larger down payment on a bigger home.
Alternatively, you could purchase another home outright, which means you go from owning a 10% stake in a $100,000 home to owning a 100% stake in another $100,000 home.
Secondly, you can acquire a home equity loan or cash out some of the equity in your house. We’ll discuss this option in more detail below, but generally, it gives you a cash lump sum by using your equity as collateral, and the more equity you have, the more you can receive.
How to Increase Home Equity
Your number 1 goal as a homeowner is to build your equity with as little risk as possible. Put all your efforts into owning more of your home, but make sure your chosen tactics are not placing your house at risk.
If you put every penny you have towards increasing your monthly payment in month 1, this won’t prevent you from suffering the consequences of a missed payment in months 2, 3, and 4, by which time the bank will prepare a foreclosure. Just because you pay $5,000 more than required one month, doesn’t mean the bank will overlook the next five $1,000 minimum payments.
Here are a few ways you can increase your equity before and after purchasing your home.
Increase Your Down Payment
The easiest way to increase home equity is to make a large down payment. This will increase the share that you own and allow you to benefit more from future price fluctuations. To return to the example we used above, let’s imagine that you buy a $100,000 house with a 20% down payment instead of 10%.
The lender gives you $80,000, the house doubles in value, and your 20% stake rises to 60%, just like that! More importantly, as discussed below, 20% is an important number as this is the minimum that many lenders require for home equity loans. As far as lenders are concerned, you don’t start having a say until you hit that magical 20%, and the fastest and cheapest way to do it is to increase your down payment.
According to a report published in 2019, close to 7 out of 10 homeowners regret not making a larger down payment when they purchased their homes. They act quickly, getting a home with minimal requirements and often increasing their interest and reducing their options in the process. Only when the honeymoon period is over, and their head takes over from their heart, do they begin to regret this.
Do your future self a favor and avoid making the same mistake. Increase your down payment, purchase discount points, and accumulate the funds you need to claim more of your house at this early stage.
Make Your Loan Payments
It’s important to keep meeting your monthly mortgage payments. Not only will this increase your home equity by gradually repaying your loan, but it will also prevent the lender from foreclosing and taking your property from you.
However, just because you pay $1,000 on your loan every month doesn’t mean your debt will reduce by $12,000 at the end of the year. This is an assumption that many borrowers make. In actual fact, if you’ve just started making repayments your debt won’t even reduce by half that.
Your monthly mortgage payment consists of insurance, taxes, principal, and interest, the latter two of which account for the majority share. The insurance and tax payments won’t change over the term, and your total payment will remain the same as well. However, the amount that goes toward the interest and principal will gradually change, beginning with a 60% to 80% swing in favor of interest and then gradually favoring the principal.
For example, if you borrow $200,000 with a 5% APR and a 30-year term, your monthly payment will be fixed at $1,073,74. In the first month, $833,33 of your payment will go towards the interest and just $240,31 towards the principal. This means that just 23% of your payment goes to the actual balance.
A year later, $13 less will be paid to your interest and $13 more to your principal. In ten years, $459.70 will go to the principal and $613.94 to the interest. In another ten years, the split will be $757.12 and $316.52 in favor of the principal, and in the final years the payments will mirror those first few years, only now most of the money is hitting the actual balance.
So, what does this mean? Well for one thing, it means you’re not clearing the balance as quickly as you thought. But more importantly, it means that if you want to hit the principal and clear it quickly, you need to increase your monthly payment. If we return to the example used above and assume a monthly payment of $1,073,74, it would take an additional payment of just under $250 every month to double the amount of money that goes to your principal.
Increase it to $1,500, and you’re greatly reducing the term and the total balance, but more importantly, you’ll increase your equity stake with every passing month. And unlike simply reducing your term and increasing this payment right off the bat, you’re under no obligation to pay this extra amount. If you have a few difficult months, you can focus on making the minimum and wait until you get back on your feet.
Reduce Your Loan Term
The longer your term, the more interest you will pay and the longer it will take to build your equity. By reducing the loan term you will build equity quickly and own 100% of your home in less time.
In the example above, we noted that a 30-year, 5% mortgage of $200,000 requires a monthly payment of $1,074,64, and initially puts just 23% of your balance toward the principal. What’s more, over the 30-year term you will repay $386,513,24, nearly twice the amount you borrowed.
If we reduce the term to 15-years, however, you’ll pay just $284,685,48, over $100,000 less! Your monthly payment will be $500 higher, but 47% of that goes toward your principal in the first month, and after just 15 months more of your money will go towards the principal than the interest.
Wait for a Better Interest Rate
If your credit score is poor and your debt-to-income ratio is high, it’s worth taking some time to fix your credit report, improve your score, and give yourself more sway in negotiations. A mortgage is a huge debt taken over the course of many years—even the slightest credit score changes could equate to thousands of dollars’ worth of interest payments.
If your score is already respectable and you’re being offered a good interest rate, this doesn’t really apply. But if you only just made the cut, then give yourself a few more months or years to improve your score and build a bigger down payment in the process. We wrote a guide on improving your credit score that can help you with this, but here are a few quick tips to get you started:
- Pay off Debt: Clear as much of your debt as you can, but bear in mind that some debt payoff strategies, including debt settlement and bankruptcy, may do more damage to your score in the short term.
- Make More Payments: Keep making your monthly payments on all debts and increase them when you can, clearing them sooner rather than later and avoiding any missed payment penalties.
- Avoid New Accounts: Opening new credit accounts can reduce your credit score and your chances of acquiring a favorable mortgage offer. Open only the accounts that are absolutely necessary.
- Use Secured Credit/Loans: Secured credit cards, lending circles, and credit builder loans can help you build credit without accumulating debt and could make a significant impact in just a few short months.
- Increase Limits: Your credit utilization ratio accounts for a sizeable portion of your credit score and is impacted every time you reduce your available credit or increase your accumulated debt. Keep balances low, increase credit limits where possible and don’t cancel your credit cards once you have cleared the balances.
Renovate and Upgrade
Simply throwing money at your home isn’t enough to increase its value. Unless you can save money on labor or tools, you’ll spend more on those renovations than they will ever earn you. However, there are exceptions, areas where you can invest a little time and money and greatly improve your investment.
This is often true for bathroom and kitchen renovations, especially if your current fixtures are old and tired. It’s also true every time you add an extra room to your home, such as when you convert an attic or basement. Be careful, however, because you’re investing, not spending; you’re thinking about the property’s value in a few years, not your enjoyment of it today.
A house is an investment and is therefore subject to capital gains tax, which is an income tax charged on investments at the point of sale. If you profit from these investments, you’ll be required to pay capital gains tax, the rate of which will depend on the type of investment, as well as your location and income.
This is true for homes, as well, but as with all investments, any money that you put towards it is classed an expense and is therefore exempt from taxes. Every improvement you make to your home, therefore, may be exempt.
Improve the Curb Appeal
One of the easiest ways to increase the value of your home is to improve its curb appeal. This term is used to refer to the exterior of your home, including everything from the yard and the driveway to the garage door. It’s anything that a prospective buyer can see when they drive past or stand outside your home, and it will help to draw more buyers inside.
Many of these changes can be made with a few simple tips and tricks, all of which we have discussed in our guide to improving the value of your home. For a quick overview, see below:
- Buy a New Garage Door: Many houses still have old, rusty, dilapidated garage doors. This will turn a prospective buyer away, so get rid of it and buy a new one, preferably a modern, electronic one.
- Fix Your Lawn: Cut the grass, add some flowers, and turn that rotten green patch into something that inspires your visitors and makes them long for sunny days spent lounging on the lawn.
- Lose Clutter: Do you have kids’ toys sitting in your driveway or on your lawn? They don’t look untidy to you because you’re so used to seeing them every day, but they could put prospective buyers off.
- Lick of Paint: Give your home a quick lick of paint to freshen it up, focusing on the door, garage, and anywhere else that looks a little shabby.
- Clean the Mailbox: Many mailboxes are just as derelict and neglected as garage doors, and fixing them is just as cheap, easy, and important.
Refinance Your Mortgage
Your mortgage lender isn’t interested in refinancing your mortgage just because you want better terms and have spent a few years meeting your payments.
However, if your financial situation has improved then it could be worth shortening the term. As discussed above, there is a massive difference between a 30-year term and a 15-year term, a difference that could cost you up to 50% of the loan amount in the example cited previously.
If you refinance your loan at a later date you may not get all of these benefits, but you’ll still reduce the interest and shave tens of thousands off the total balance. You’ll build equity quickly and will clear your mortgage much sooner.
You don’t need to reduce your term by half to make this work. Big savings can be made just by reducing your term by 5 or 10 years, and while you will pay more per month, you’ll pay much less over the term.
How to Use Your Home Equity
Your home equity can be used in several ways. These are generally available as soon as you have at least 20% equity, but the more you have, the easier these options will become and the more benefits there will be. There are also some requirements regarding credit scores, purchase price, age, and more.
Home Equity Loans
A home equity loan is a secured loan that uses your equity as collateral. The lender will give you a lump sum to spend as you see fit, and in return they’ll ask for fixed monthly payments.
The lender will typically request that you have at least 20% equity in your home and they will give you a fixed lump sum based on this equity, the amount you need, and the payments you want to make.
But that’s not all. Simply owing equity isn’t enough to acquire a home equity loan. The lender will also insist that you’re in full time employment, have a debt-to-income ratio of less than 43% (some lenders allow this to be as high as 50%) and maintain a respectable credit score.
Secured or not, lenders still want to know that you can afford to make the loan payments as foreclosures are expensive and time consuming and lenders are generally keen to avoid them.
Contrary to what you might think and what cynical borrowers would have you believe, lenders are not crossing their fingers and hoping you will default so they can get their hands on your house. The best-case scenario for them is that you keep making the payments every month.
Home Equity Line of Credit
A home equity line of credit, known simply as a HELOC, works in much the same way as a home equity loan, only you’re given a line of credit as opposed to a lump sum. The easiest way to understand the differences between a HELOC and a home equity loan is to imagine that the former is more like a credit card while the latter is more like a personal loan, only both are secured against your home.
A HELOC is also split into two periods. During the first period, known as the “draw”, you take the money as you need it, borrowing sums here and there and repaying only the interest.
Once this period ends, you’ll be required to start paying off the balance. Again, it’s a lot like a credit card in this sense, only you’re limited to two billing cycles and these tend to last for years and not just 30-days.
A cash-out refinance mortgage essentially swaps your current mortgage for a new one, only the new one is acquired at a larger sum, with the difference then paid to the borrower.
For example, imagine that you have a $200,000 house with a $100,000 mortgage left on it. You refinance your mortgage for $150,000, with $100,000 going towards the actual mortgage and the remaining $50,000 given to you as cash.
The larger sum generally equates to higher monthly payments and a greater sum of interest paid over the term. However, if you increase the term as well as the payment, the total interest you pay during the lifetime of the mortgage will increase but your monthly payment may decrease.
A reverse mortgage is one of the best options for cashing the equity in your home, providing you’re old enough and have enough equity to qualify. It’s offered to homeowners over the age of 62 and allows them to tap into the equity accumulated over the years, swapping all that valuable theoretical real estate for a cash sum.
There’s no monthly payment obligation—everything is due when you sell the house or die. This is a great option for homeowners with 100% equity, because while they’ll still be required to cover home insurance and taxes, their other obligations will be minimal.
Pros and Cons of Using Home Equity
Home equity loans are some of the best secured loans available. A secured loan is one that uses cash or assets as collateral, allowing the lender to collect if the borrower defaults. The reason they charge lower interest rates when compared to unsecured loans is that they provide the lender with more options if the borrower defaults.
A default on an unsecured debt causes problems for all involved and for the lender it often means chasing and then charging-off or selling the debt. They may lose all or most of the value of the debt and there’s very little they can do about it, except report all missed payments to limit the borrower’s chance of acquiring future credit.
To account for this risk, lenders increase terms and penalties, essentially earning more money from the good borrowers so they can offset the damage done by the bad ones. With secured loans, the risk is negligible, so they don’t need to offset quite as much and can keep the interest rates low.
As a result, you’re more likely to receive a favorable offer on a home equity loan or line of credit than you will on an unsecured loan or credit card. In this sense, it’s the best way to get the money you need, but at the same time, the fact that it’s secured means you will lose the house if you fail to make payments.
It should also be noted that home equity loans require you to use what little assets you have as collateral. You may have spent years prizing that collateral away from the bank, giving yourself a valuable asset in the process, only to give it right back to them (or to another bank) when you agree to a home equity loan.
You will still own the house and it will eventually be yours if you keep making the monthly payments, but your obligations have increased, your risks are greater, and your options for acquiring low-interest credit in the future are slim.
How Can Home Equity be Used?
Lenders rarely concern themselves with how your equity is used, only if you can afford to make the monthly payments or not. It’s important, however, not to play fast and loose with this cash. It isn’t an unexpected windfall; it isn’t a lottery or inheritance.
You’re essentially just converting a valuable asset into cash, and if you spend it frivolously on something that doesn’t have any tangible worth and won’t improve your net worth, such as a vacation, you’ll quickly live to regret it.
Of course, it’s a different story with a reverse mortgage. In this case, you’re just cashing an asset that would otherwise be passed onto your heirs, and that cash can help you to live a little and enjoy your retirement. With other home equity loans, however, you should consider limiting your purchases to the following:
We have already discussed the benefits of home improvements, as you can increase the value of your home and deduct the costs from your capital gains tax.
We would never recommend using a home equity loan to make improvements with a view to increasing the value and selling, but if you’re making improvements for your own enjoyment and those improvements just so happen to increase the value of your home, it’s a win-win.
The number of seniors with college loans has increased by over 1,000% in the last couple decades, and it’s all because parents/grandparents are acquiring loans to benefit their family members.
If your kids or grandkids have higher education in their sights, there’s a good chance you will be lumbered with the bill, in which case a home equity loan may be more suitable than student loans. That’s not always the case, however, because while the interest rates and payments are lower, you also have fewer options with regards to forgiveness programs.
Starting a Business
Got a good idea and the passion to make it work, but need a little capital? A home equity loan can help. However, you have to be very careful, as the path to business success is littered with the broken, beaten, and defeated bodies of countless entrepreneurs.
These people invested everything they had, more than they ever should have invested, and in the end, they lost everything. It’s difficult to look at things subjectively, especially if you’re passionate about an idea or desperately want to save a failing business, but as discussed in our guide on how to start a business for less, it is possible to make your mark without risking all your money and assets.
Finally, while we probably don’t need to tell you this, you should never take out a home equity loan just to invest in an existing business or help your friend launch one. It doesn’t matter how much you love them or how much they’ve convinced you that it’ll be the next big thing. Don’t risk your financial future to benefits theirs, and don’t swap your assets for stock just because you saw a show about stock market investing and it looked easy.
You’d be surprised how often this happens and it rarely ends well.
Debt can drag you down and cost you everything you have, and yet the average American gets locked into a persistent cycle of debt as soon as they turn 18 and they remain there for as long as they live, with more than 75% dying in debt.
It’s an issue we have discussed many times on this site and something we won’t get into again here, but needless to say, debt is expensive, it’s stressful, and the sooner you clear it, the better.
A home equity loan can help you with this. On the one hand, you’re swapping a large secured debt for multiple smaller debts, so you’ll still have debt to contend with. But it won’t be as demanding, the interest payments won’t be as high, and you could save thousands of dollars.
The average American consumer has around $6,000 worth of credit card debt, which could cost upwards of $4,000 in interest if they stick with the minimums. On top of that, they have student loans, personal loans, store cards, car loans, medical debt—it all adds up to nearly $40,000 worth of non-mortgage debt on average.
A home equity loan can clear this in one swoop, consolidating those debts, eliminating the obligations, and allowing you to sleep easily at night.