Whether it’s a car or a home, if you’ve borrowed money to pay for an asset, your payments over time are working to build equity. The equity in your home is the difference between the appraised value of your home and the payoff amount of your mortgage. If you have more than one loan on your home, both loans must be considered in calculating your equity. In plain English, your home equity is the amount of your home that you own; if you have a loan or loans on your home, part of your home’s value is owed to the lender or lenders.
Equity = Appraised Value – Mortgage Payoff
Most homes purchased for personal use are financed with either a 15- or 30-year loan. Investment properties might use a different type of loan. As you continue making payments, in theory, you are building equity as the balance you owe goes down. The theoretical part can come into play in the early years of a mortgage because your equity calculation is based on the appraised value of your home, which considers the condition of your home and competitive market data. Markets can change rapidly as can the condition of the home, so home values aren’t a static figure. Over time, appraised values for homes can go up or down. As you get further into the loan and pay down more of the mortgage balance, it’s less likely that you’ll lose your equity entirely, but it is possible for your equity amount to change.
Equity exists on paper. You can’t see it in your bank account or hear it jingle like coins in your pocket. If you never touch it, your equity will stay on paper until you sell your home. If market values fluctuate dragging appraised values and equity values around in the process, you might not even be aware. In a way, your equity is a hidden asset. Often, it’s best that it stays hidden, but there are ways to access your equity and we’ll discuss some of the more common methods as well as analyze some of the risks and benefits of each.
Let’s say you bought your home for $100,000 with a 30-year mortgage. If you put down 20%, you have $20,000 in equity as a starting point. If you bought your home with little or no money down, your equity position could be as low as $0 or could even become negative if the market changes and drags down appraised values.
Over time, as you pay down your mortgage, your equity will increase. To use the same example of a $100,000 house and assume you put $20,000 down, here’s what the numbers might look like over time. In this example, we won’t add any value for appreciation. We’re also assuming a 5% interest rate for the mortgage. In the early years of a mortgage, most of your payment goes to the interest payment. In the latter years, your payments are directed primarily at principal.
Year 1 ending balance: $78,819.71
Year 10 ending balance: $65,073.65
Year 20 ending balance: $40,489.81
Year 30 ending balance: $0
If you were watching the numbers, you’ll notice that you paid off the same amount in the last 10 years as you did in the first 20 years. That’s because more of your mortgage payment was diverted to interest in the early years of the mortgage.
Assuming no change in appraised value, your equity is about $21,000 after a year, most of which was your down payment. After 10 years, your equity is about $35,000. After 20 years, you’re up to about $60,000 in equity.
Appraised values don’t remain constant for decades, though. In most cases, you’ll see some appreciation over the years. On the low side of the scale, you may see an average home value appreciation of 3%. After 20 years, your home that appraised at $100,000 when you purchased it is now worth $180,000 at a 3% appreciation rate.
After 20 years, you owe about $40,000 but the home is worth $180,000, which gives you $140,000 in equity. In reality, the appreciation closely mirrors the inflation rate in many markets and you had some expenses along the way, like maintenance, taxes, insurance, and interest, but you still show $140,000 in equity – at least on paper. Both home values and equity will show more dramatic increases over a longer duration. If you look at a 10-year time frame, you’ll owe $65,000 and the house will be worth about $134,000, giving you about $69,000 in equity.
If you plan to access your equity without selling your home, you’ll need to utilize one of several credit products. We’ll look at two popular options.
Much like your mortgage, your home equity loan uses your home to secure the loan. Before we talk about numbers and how home equity loans work, it’s important to understand that there is a risk.
Your home equity is providing a safety net and acting as a shield against inflation. If you access your equity, you remove the safety net and essentially spend your inflation hedge. If you have a financial emergency, like a health issue, a change in employment, or an income-earner leaves or passes away unexpectedly, you now have two home loans to pay but you may have less income available to service the loans. If you’re unable to make payments, either lender could foreclose on the home.
The first mortgage is the senior lien and will be paid first with the proceeds of a foreclosure. If you’ve already taken the equity, you could lose your home and get nothing from the sale of the house. If the proceeds of the foreclosure sale aren’t enough to pay the outstanding debt, either lender could sue you personally to collect the unpaid balance.
In a perfect world, home equity seems like “found money”. However, the world isn’t always perfect and sometimes bad things happen to good people and good families. Be cautious with any type of home borrowing.
In our earlier example, after 20 years, you had about $140,000 in home equity. It may seem like you can borrow this amount, but the amount available to you may vary depending on several factors. Many lenders will not let you borrow more than 90% of the home’s value. In our example, the home value is $180,000. You’d need to leave a buffer of 10%, or $18,000. The amount of equity you can access is $122,000 ($140,000 – $18,000).
Most home equity loans also have closing costs which can total a few thousand dollars. For the sake of simplicity, we can estimate closing costs at $3,000, which will include application fees, appraisals, title work, and possibly surveys. This amount is typically taken as part of the loan, but you may have to pay for appraisals or application fees out of pocket because there’s no guarantee of loan approval or that you’ll take the loan and the lender doesn’t want to lose out on these costs.
A home equity loan is taken as a fixed-term loan, which means the loan will be repaid according to a fixed schedule which can range from 5 years up to 30 years. Your interest rate for the loan can vary based on several factors, including your credit score, the loan-to-value ratio, and the term of the loan. Bad credit, high loan-to-value ratios, and longer terms all typically result in higher interest rates for home equity loans. In most cases, the rates for home equity loans are higher than the rates for a first mortgage.
People have many reasons for taking out a home equity loan. The amount you borrow is paid as a lump sum, so it can be useful in several situations. Common reasons for taking a home equity loan include credit card debt consolidation, home improvements, or emergencies. Because a home equity loan brings additional risk and reduces the inflation hedge your home is providing, it’s important to consider your reasons carefully. It isn’t uncommon for people to use their part of their home equity loan to treat themselves to vacations, new cars, motorcycles, jewelry, cosmetic surgery, or the latest gadgets. Life should be fun but there is probably a better way to pay for these types of purchases than to use your equity and pay interest on purchases for up to 30 years.
The way you use your home equity loan can affect the tax treatment of the interest expense as well. New IRS guidelines limit interest deductions to loan proceeds used to buy, build, or substantially improve the home used as collateral for the loan. As a homeowner, the interest on your primary home loan is usually eligible for an itemized deduction. Other uses of home loans may lose the tax benefit.
A home equity line of credit gives you access to part of your home equity but instead of being given a lump sum at closing, you’ll have a line of credit that you can use – or not use. You pay only for the balance you’ve borrowed.
Typically, you’ll pay a variable interest rate for a HELOC but some lenders offer fix-rate conversions. When interest rates are rising, it can be more expensive to borrow money with a home equity line of credit.
A HELOC is a fixed-term loan, meaning the equity isn’t available indefinitely. Typically, your line of credit is only available for 10 years, which is called a “draw period”.
Your loan might then be structured in one of two common ways:
The repayment period follows the draw period and can last for up to 20 years, depending on the terms for your line of credit. If you pay down the principal during the draw period, you’ll be able to access the equity you’ve paid back – but only until the end of the draw period. The limited draw period reduces default exposure for lenders.
A HELOC may have lower closing costs than a home equity loan but often also has a higher interest rate. Some lenders may offer a no-closing-cost line of credit, but this may be limited to recent purchases. It isn’t uncommon for lenders to offer a home equity line of credit when you are securing a mortgage because many of the closing costs can be shared between the two loans.
There are a few situations where you can make a math case for taking a second home loan, including either a home equity loan or a home equity line of credit. If you’re buried in high-interest debt, using your home equity may be a better solution than trying to dig your way out. However, if you have the option of earning more money (or spending less), paying down the debt without using your equity is a preferable option because of the costs and risks associated with a second home loan.
Another situation where a home equity loan may make sense is if you are using the money to do home improvements that will significantly improve the value of your home. Choose carefully, however, and match improvements to the neighborhood market. Spending $50,000 on a kitchen remodel for a $100,000 home surrounded by homes in the same price range may not provide a long-term return because buyers can choose a less expensive home in the neighborhood and may not want to pay a premium for the kitchen upgrades you’ve done. Pools, hot tubs, and similar luxuries also often have more value for you than for future buyers, making them a less suitable use for home equity. You won’t get your money back at resale.
Emergencies may be another reason to tap your home equity. Be aware that if the emergency is a job loss, you may not be able to get a home equity loan because your income is reduced or gone altogether. Medical emergencies can happen, however, and if someone’s health is at risk using part of your home equity may be an option.
Another way people use their home equity is to fund the purchase of investment properties. There’s a math case to be made for the long-term value in using home equity to purchase another property that will produce income and build equity on its own. There’s also risk, as many families learned during the housing crisis. If you choose to use your home equity to fund investment property purchases, do your research and use only a small part of your equity. Where many people get into trouble with investment real estate is by not leaving any room for mistakes or changes in cash flow. Any experienced real estate investor will tell you that both will happen.
Many families have lost their homes or found themselves trapped in a home with negative equity. If you choose to use your home equity, do the math on the true cost of borrowing and leave yourself a large margin for error. Life changes quickly and a change in your household or employment can put your home at risk.