Equity can be defined as the market value of the home minus any remaining liens, or, more simply put, the percentage of your home that you own. It is important to realize that equity is, in fact, an asset and is factored into your overall net-worth. In a sense, it is how much of your own money you have paid toward the overall loan.
For example, if a home is purchased for $200,000 with a 20% down payment, the total equity at the time of the purchase is $40,000. You can’t know your home’s true equity is until it is sold.
Equity is an asset and like most assets, there is room for growth. Equity begins with the down payment. With a higher down payment comes more equity. Building equity in your home can be as simple as paying your monthly mortgage. For every dollar paid, you own more of your home and the lender relinquishes part of the debt. Unlike most assets, like a car that depreciates over time, a house actually appreciates over time.
As your house’s overall value grows, so does your equity. Home improvements such as remodeling a bathroom, redoing the siding, and landscaping all contribute to the value and equity of your home. Check out what similar homes in your area sold for to get a better understanding of your home’s market value.
Equity is a fluid asset. It goes up and down. If you’re not careful you could end up with no equity and still be in debt to the lender.
The most common and substantial way equity is reduced is when a person takes out a home equity loan or refinances. When this happens, the owners relinquish their equity and, in return, are able to withdraw that money.
When an owner ignores regular maintenance, the home may fall into disarray, causing it to become a money pit. Not only does this affect the value of the house but every penny spent on repairs comes out of the equity. Preventative maintenance should protect most owners from losing equity in this way.
Unfortunately, equity is linked to the market value of your home. When the market value falls, Equity falls as well. If your equity is $40,000 and the market value of the of your home drops by $30,000, that would only leave $10,000 left in equity.
Home Equity Loans
Now that we understand what equity is, lets better understand how you can access that pool of money. First and foremost, anyone with at least a 620 credit score, provable income, and proof of credit history can qualify for a home equity loan. Lenders also look into your loan-to-value ratio or LTV. Generally, you will need at least 20% equity and the loan may be limited to 85% of your existing equity.
Home equity loans offer a homeowner a large pool of money that can be borrowed on, usually, at a low-interest rate. These also take the form of a home to refinance loan. Owners have two options when it comes to home equity loans:
- A Lump Sum Loan – Owners may pull out all their equity at one time and turn it to liquid capital. The borrower is responsible for paying a flat monthly rate over the life of the loan, typically 10 to 15 years. Although the interest is usually fixed, it is calculated based on the full amount of the loan. This loan can be useful for full home rehabs or even consolidating high-interest loans, such as credit cards.
- Home Equity Line of Credit (HELOC) – This option allows borrowers during the Draw Period to withdraw funds as necessary. Interest is usually variable, so in the end, you may pay more than what you expected. The Draw Period may last for 10-15 years. During that time borrowers will make small payments toward the loan. After the Draw Period ends the loan transitions into the Repayment Period when borrowers must begin to aggressively pay off the loan, possibly through a balloon payment. This form of credit can be useful for minor home renovations, college tuition, medical bills, and much more.
Author: Tyler Karstensen