What Is Equity in Real Estate?

By
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Mar 21, 2022
5 min

Homeownership comes with major perks. It allows you the freedom to create your own unique living environment and an increased level of financial stability. It also offers you the ability to build equity in your home.

This article will outline everything you should know about home equity, how to build it, and the best way to use it.

Why do we buy real estate?

Homebuyers are driven by several factors, including a desire for independence, control, and self-expression, which can be summarized in an acronym known as U.P.T.E.E., which refers to a property owner’s bundle of rights.  

These rights are as follows:

  • Use: The right to use a property for any purpose.
  • Possess: The right to live on the property and keep others out.
  • Transfer: The right to transfer the property by sale or by gift.
  • Encumber: The right to borrow money and use a property to secure the loan.
  • Enjoy: The right to peace, quiet, and enjoyment on the property.

With these rights comes the possibility to build value, or home equity, in your home. That equity allows the homeowner’s right (and defined by the right to “encumber”) to borrow money against the property to secure a loan.  

What is equity?

In the simplest terms, home equity is the amount of the home you own. It’s the difference between the amount of money that you owe the mortgage lender and the amount of money that your home is worth. 

Over time, you will make mortgage payments on the house, reducing the loan’s principal balance, thus building equity by increasing the percentage of the home you actually own.

How does equity work?

If you were to purchase a home worth $300,000, for example, using a $30,000 down payment, you would automatically have $30,000 of equity at closing. 

As you make each payment toward your mortgage, your loan balance will decrease. This builds more equity as long as the value of your home remains the same or increases over time.

Once you pay 100% of your mortgage, you will have 100% equity.

Sometimes, home prices can drop sharply, and a homeowner may owe the lender more than what the home is actually worth.

Using our example, if the home’s value dropped to $200,000 and you still owed $240,000, the loan would be considered “underwater,” or you would have “negative equity.”

How do you build equity in your home?

There are several different ways to build equity in your home, including:

  • increasing the down payment you put on your home at the time of purchase.
  • increasing your mortgage payment amount or making additional payments
  • refinancing and shortening the term of your loan.
  • investing in home improvement and remodeling projects to increase the home’s value.

What is the best way to use your equity?

You can tap into the home equity you have built as a low-cost and convenient way to borrow money and take advantage of great interest rates.

Depending on a person’s credit score and financial history, a lender will generally want to see a loan-to-value (LTV) ratio of 80% or less. That means their home equity is at 20% or more before the lender allows them to borrow against the equity in their home. 

Lenders will typically let you borrow up to 80% of the total value of your home. 

Most home equity loan terms will range between five and 20 years. But borrows can take 30 years to pay a home equity loan.

Because a significant amount of a borrower’s monthly loan payment goes directly to interest payments at the beginning of the loan term. 

It can take five to seven years before a homeowner can reach the 20% equity threshold.

There are several reasons why you would use your home equity to borrow money, such as…

Covering business expenses

Many small business owners will tap into home equity and use the money to help grow their business. The move is particularly advantageous when avoiding higher interest rates associated with a small business loan.

Finance emergency expenses

Emergencies happen. Most financial advisors suggest having an emergency fund covering six months of your living expenses. But that’s hard for most people to do. A home equity loan may be your best choice when faced with an emergency and no way to get the finances you need. 

Consolidate your debt

Home equity loans can be great tools for consolidating high-interest debts at lower interest rates. You can use this method to help you pay off personal debts like credit cards and car loans. 

Pay for college

If the lender approves, you can use your home equity for covering college expenses. Although student loans are usually your best bet for paying college expenses, home equity loans can sometimes offer better low-interest options. 

Finance home improvements

Home equity loans are most commonly used for home improvement projects because, in addition to making your home more livable, comfortable, and desirable, the upgrades that you make can potentially raise the house’s value, thus building more equity. It can really be a win-win. 

Final thoughts on home equity

There is no doubt that most Americans who can purchase a home do so to put a roof over their heads. Still, through equity, homeownership truly becomes an investment. 

A home equity loan serves as a valuable tool for the responsible homeowner who needs access to cash. Low-interest rates and tax deduction opportunities make a home equity loan an excellent choice for any homeowner. 

They just have to make sure they have a steady income that can repay the loan.

TL;DR: Equity is the difference between the money owed to the lender and the value of the home. This value can be borrowed against (the bank gives you money in the amount of the value of your home) to finance all of life's expenses. That's what makes equity such a powerful tool for homeowners to increase their wealth.

By
|
Mar 21, 2022
Terminology
5 min