Home equity is the value of the ownership stake you’ve built up in a home that you own. In simple terms, it’s the difference between the value of your home and how much debt you have remaining on your mortgage.
Building home equity can be done in two ways:
Every time you make a mortgage payment, your equity increases. If real estate prices increase in your area, so does your home equity. On the flip side of things, your home equity could decrease. This happens if property values drop or if you refinance your mortgage to borrow more money.
Figuring out your home equity is simple. Let’s say you purchased a home for $650,000 with a 20% down payment, which is $130,000. That means your outstanding mortgage is $520,000. Based on this information, you would calculate your home equity as follows.
$650,000 (home value) – $520,000 (outstanding mortgage) = $130,000 (home equity)
Now let’s say real estate prices steadily climbed over the next five years, and your home is now worth $50,000 more. You also paid down your mortgage during that time by $50,000. That means your outstanding mortgage is now $470,000, and you have a property value of $700,000. To calculate your current home equity, you’d use the same formula but with the updated numbers.
$700,000 (home value) – $470,000 (outstanding mortgage) = $230,000 (home equity)
Many people assume that home equity only refers to the amount you’ve paid off on your mortgage, but it also includes any property value increases. During hot housing markets, you could quickly see your equity grow.
Having home equity is important because lenders will allow you to tap into a portion of it. What you do with that money is up to you, but some common things include doing renovations, purchasing an investment property, and paying for your kids’ post-secondary education.
This process is known as a home equity loan, where you’re borrowing from yourself. Since your home acts as collateral, financial institutions will usually give you a better interest rate than an unsecured loan or line of credit. How much equity you can access depends on the type of home equity loan you get.
A home equity line of credit (HELOC) has become a very popular home equity loan in recent years. A HELOC gives you access to your home equity in the form of an account. It’s basically a revolving line of credit that you can access at any time. If you withdraw from it, you’ll need to make monthly minimum payments. It’s sort of like using a credit card, but with a higher limit and lower interest rate. The amount you’ll be able to access is set at the beginning of your term, but it can’t exceed 65% – 80% of the value of your home.
As the name implies, when you get a second mortgage, you’re getting another mortgage on top of your primary mortgage. The total of both these mortgages can’t exceed 80% of your home’s value. The benefit here is that you’re able to pull out your home equity as a lump sum in cash. While this can help you with your budgeting, it’s worth noting that second mortgages will have a higher interest rate than standard mortgages. That’s because the lender of the second mortgage has a lower repayment priority than the primary lender. If you were to default, the primary lender would be repaid from the home sale’s proceeds first, and the second mortgage lender would be repaid from any remaining funds. As such, the second mortgage lender has more risk, which is why they charge more.
Another way to access the home equity you’ve built is to refinance your mortgage. Although the maximum amount you can borrow is 80% of the total value of your home, minus the balance on your mortgage, it can still be beneficial. Since you have the option to borrow more money when refinancing, you can use some of the equity built for other things, such as paying down high interest debt. While there may be some fees involved, it may be cheaper than getting a second mortgage.
Having more home equity is never a bad thing. That said, if you’re considering a home equity loan, you need to think about the pros and cons before you start using your home to access some cash.
When used responsibly, accessing your home equity can be very beneficial. That said, not everyone will be comfortable borrowing against the equity they’ve built. Take a look at your financial goals and see if accessing your home equity will help you reach them.
Barry Choi is a personal finance and travel expert. His website moneywehave.com is one of Canada's most trusted sites when it comes to all things related to money and travel. You can reach him on Twitter: @barrychoi.