As a homeowner, you possess an extremely valuable asset – the equity you’ve built up in your home. Home equity represents a higher level of financial security and stability and is one of the largest sources of net worth for most people. It’s, therefore, important to understand what exactly home equity is, how it works, and how it can be used to your advantage.
- Home equity represents a higher level of financial security and stability, and is one of the largest sources of net worth for most people
- The equity in your home can increase in two ways simultaneously – as you pay down your mortgage and as the home’s market value increases
- Home equity is a valuable source of capital and borrowing against it can make a lot of sense if used under the right circumstance and for the right purpose
What’s home equity and how does it work?
If you’re like most people, you bought your home with the help of a mortgage. Even though you’re the homeowner, you don’t actually own your home outright (your lender who issued the mortgage also has a stake). You do, however, own what’s known as equity, which is represented by the market value of your home minus the balance of your mortgage. In other words, home equity is the value of your ownership stake.
How do you build home equity?
The equity in your home can increase in two ways simultaneously – as you pay down your mortgage and as the home’s market value increases.
By making your monthly payments, you pay down the mortgage balance, thereby increasing your equity (the less you owe, the more equity you have). Your mortgage payments are applied to both the loan principal and interest. As the loan amount decreases, an increased amount of each payment will be applied to the principal and your equity increases accordingly.
Your mortgage payments are applied to both the loan principal and interest. As the loan amount decreases, an increased amount of each payment will be applied to the principal and your equity increases accordingly
In terms of increasing value, you may want to consider making improvements to your home or property. While it’s generally a good idea to invest in the betterment of your home, it’s important to note that its real market value is ultimately dependent on a number of outside factors. Housing demand, household debt, inflation and unemployment among other things, all play a role in the overall health of the economy, which, in turn, impacts the state of the real estate market and, ultimately, your home’s value.
How do you calculate your home equity?
To determine the amount of your equity, you need to establish the home’s current market value and subtract the existing balance of your mortgage. You can gain a general idea of the home’s value by looking at comparable house sales in your area but, to determine its real market value, you’ll need a professional property appraisal. A certified home appraiser provides an unbiased evaluation of your home based on its overall condition, size, neighbourhood, key features and amenities. Once this value has been confirmed, simply subtract your remaining mortgage balance to determine your equity. Your lender will be able to provide you with the amount owing on your mortgage if you’re unsure. Now that you’re aware of how much equity you have in your home, what can you do with it?
To determine the amount of your home equity, you need to establish the home’s current market value and then subtract the existing balance of your mortgage
Reasons to borrow against home equity
If you’re in need of some extra money to fund a renovation project, consolidate high-interest debt, finance a large purchase or even establish a rainy-day or emergency fund, borrowing against your home’s equity makes good sense. Depending on your financial situation, most lenders limit the amount you can borrow – typically the maximum is up to 80% of the appraised value of your home.
Most lenders typically allow you to borrow up to 80% of the appraised value of your home
Two types of home equity loans
There are two types of loans you can obtain by borrowing against the equity in your home: 1) Home Equity Loan; and 2) Home Equity Line of Credit (HELOC). It’s important to understand their respective features before determining which is best for your unique circumstances.
A home equity loan provides you with a one-time lump sum payment. The interest rate is most often fixed so you know the exact amount of each repayment for the duration of the loan’s term. Similar to your mortgage, each monthly payment reduces the loan balance and interest. A home equity loan may include flexible repayment options and is useful when you need extra money but you’re unable to obtain a more traditional loan due to a low credit score or high debt-to-income ratio. (See: What’s an Ideal Debt-to-Income Ratio for a Mortgage?)
A HELOC is similar to a credit card in that you receive approval for a specific amount to borrow against and, as you pay it down, the credit revolves – becomes available – for you to use again. A HELOC also provides you with flexibility to access money as you need it and in the amount you need, paying interest only on what you withdraw. Interest rates on HELOCs are typically variable, which may also prove advantageous over time.
Both types of home equity loans are considered second mortgages, as they’re additional loans taken out on a property in secondary position to the first – primary – mortgage on your home. A home equity loan can be with the same lender as the first mortgage holder or a different one. While interest rates are still low with a home equity loan, they’re higher than first mortgage rates since a first mortgage always takes repayment priority over a second mortgage, which makes a second mortgage riskier for lenders.
Home equity loans are considered second mortgages, as they’re additional loans taken out on a property in secondary position to the primary mortgage on your home. As a result, rates are a little higher because the risk to lenders is greater for a second mortgage
Home equity loan vs HELOC key features
Loan – Predictable
- Provides a lump sum amount
- Used to finance large projects
- Fixed rate – set monthly payment + interest
- Scheduled time period for repayment
- Structured repayment plan
HELOC – Flexible
- Provides revolving credit
- Used to cover expenses as they arise
- Variable rate – payments can rise or fall
- Make withdrawals as needed
- Interest is only paid on amount used
Benefits of using home equity
Depending on the amount of equity you have, the loan you receive could be significant and much higher than what you could hope to obtain through a personal loan. Given that your home is used as collateral against the loan, it carries less risk in the eyes of your lender and, as a result, interest rates tend to be lower than other types of loans. And because you have an existing relationship and payment history with your lender, the approval process is relatively quick.
Drawbacks of using home equity
By tapping into your home’s equity, you’re taking on more debt that, like any debt, needs to be repaid. Before choosing to apply for either a loan or line of credit, you should first determine whether the state of your finances can accommodate additional payments. Also, if you decide you want to sell your house, your loan must be paid off in full before you sell. If you’re retired, nearing retirement or on a fixed income, this is likely not a good option for you, as you may have difficulty with repayment. Also, if for any reason you fail to repay the debt, or if there’s a market crash and you end up owing more on your home than it’s worth, your lender could repossess your home.
How to qualify for a home equity loan
Home equity loan requirements vary depending on the type. Your lender will assess the amount of equity you have available and evaluate your financial position by taking into account your credit score and debt-to-income ratio (DTI). (See: What’s an Ideal Debt-to-Income Ratio for a Mortgage?) The process tends to be a bit simpler, however, in that the debt is secured by your home, which protects the lender.
Your lender will assess the amount of equity you have available and evaluate your financial position by taking into account your credit score and debt-to-income ratio
Lenders set out different conditions to determine the amount they’ll lend to you. Typically, the maximum amount is up to 80% of your home’s value. To improve your chances of obtaining the maximum amount should you need it, ensure that your credit score is high (680 or above) and that your DTI is low (anything under 36%). Your lender will also assess your property’s loan-to-value ratio (LTV) to help determine the amount. LTV is calculated by dividing the appraised/market value of your home by the current amount of your mortgage. As a rule of thumb, your LTV should be 80% or less.
The equity in your home is a valuable source of capital and borrowing against it can make a lot of sense if used under the right circumstance and for the right purpose. Your home equity also represents financial security that you don’t want to jeopardize, so be sensible about its use. There are caveats to be aware of, however, so make sure you speak with nesto for guidance and advice before making any final decisions.
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