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Homeownership is one of the most straightforward paths to building wealth. The key component is growing your equity, which gradually shifts your debt into an asset.
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What is home equity?
Home equity is the current market value of your home, minus what you owe. Any gain comes from:
- Paying down the principal balance on your loan.
- An increase in market value over time. This comes from appreciation when property values grow, as well as from improvements that you make to the home.
How does home equity work?
When you purchase a home with a mortgage, ownership is shared between you and your lender. Your down payment represents your share of ownership in the home, while the lender owns the remaining stake. For example, if you make a 20% down payment, your equity at closing is 20%.
As you make payments toward the principal balance, your share of ownership grows and the lender’s share shrinks. Building home equity is a bit like investing in a long-term instrument, like bonds. Your money is, for the most part, locked up and not fully spendable until you sell the home. However, there are ways to access some of your equity and convert it into cash while you still own the home.
Home equity loan
A home equity loan is a second mortgage. It takes some of the equity that you’ve accrued in your home — typically no more than 80% — and converts it into debt in exchange for a lump sum of cash. You can spend it as you wish, but it’s safest to use it on expenses that will help grow your wealth. For example, you may get a home equity loan to finance a home improvement project, like installing central air conditioning.
You’ll pay back the loan at a fixed rate over a set term, such as 20 or 30 years. Because the debt is secured by your home, a home equity loan will typically come with a lower rate than unsecured options like a personal loan or credit card. Tying the loan to your home also comes with additional risk, as you could lose your home to foreclosure if you can’t keep up with your monthly payments.
» MORE: Best home equity loan lenders
Home equity line of credit (HELOC)
A HELOC works similarly to a home equity loan, with a few key differences. The first is that rather than receiving a loan as a lump sum, you’re converting your equity into a line of credit that you can draw from up to a certain limit. This flexibility can make it an ideal choice if you don’t know exactly how much you’ll need to borrow or if you’re financing a series of projects.
Another feature of HELOCs is that they typically (though not always) come with a variable interest rate, meaning that the rate will change with the market over time. You’ll typically have 10 years to draw from the line, and then a set amount of years to pay it back.
» MORE: Best HELOC lenders
Cash-out refinance
A cash-out refinance allows you to refinance your primary mortgage and take out additional cash from your equity in one loan. You take out a larger mortgage, which pays off and replaces the original mortgage with a new rate and terms. The remaining balance is yours to pocket.
Cash-out refinances tend to be popular with homeowners whose mortgage rate is higher than current rates, or who want to change their terms, such as extending the time they have to pay off their loan.
» MORE: Best cash-out refinance lenders
How do you find out how much equity is in your home?
A home equity calculator can give you an idea of what your home is worth and how much equity you may have if you’re thinking about selling your home or borrowing a chunk of your equity.
Additionally, an appraisal will nail down the value of your house if you want more specific numbers.
» MORE: How to determine home value
Why is home equity important?
Home equity can be a long-term strategy for building wealth.
Mortgage payments reduce what you owe while your home gains value, so paying on a house has been called “a forced savings account.” This is unlike many other assets purchased with a loan, such as vehicles, which typically lose value while you pay them off. Your home is also likely to be one of the most valuable assets you will own.
Home equity takes time to build
Another thing that helps to grow home equity wealth is time. Homeowners who stay in their homes longer are more likely to accrue equity.
Traditionally, it’s recommended that prospective home buyers follow the “five-year rule.” This is the minimum window of time where homeowners typically will have begun to build enough equity to recoup their initial purchase costs if they decide to sell. If the market happens to cool by the time you choose to sell, you may want to hang tight if possible until the market favors sellers and the value of your home increases.
» MORE FOR CANADIAN READERS: What is home equity?
NerdWallet writer Isabella Angelos contributed to this story.
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