Home Equity: What You Should Know Before Borrowing Against Your Home

Purchasing a home is often regarded as the first step towards achieving “The American Dream.” Owning your home gives you a sense of stability, ownership and can even improve your credit score. Aside from having a place to call your own, though, your home is also an investment.

If you play your cards right, then owning a home can increase your net worth and even give you access to much-needed capital, loans, and credit that you can use when you need it most.

In today’s article, we’re going to discuss everything that you ever wanted to know about home equity. First, we’ll explain what home equity is and how its build, then we’ll discuss what negative equity is. Finally, we’ll show you all of the different ways that you can borrow against your home equity and discuss some of the pros and cons of doing so.

What Exactly Is Home Equity?

Before we jump into the topic of borrowing against your home’s equity, let’s take a minute to define exactly what home equity is. A lot of people (including homeowners) are still a bit confused as to what home equity is, how it’s built, and what it means for your overall credit profile.

Put simply; home equity is the value of your home after you subtract any tax liens, home equity loans, and any other balance that utilizes your home’s value as collateral. Liens on your home could include:

  • A tax lien imposed by the government.
  • Loans that were taken out using your home’s equity (which we’ll get into below).
  • The remaining mortgage that you owe on the home.

Another easy way to understand home equity is to phrase it in the following manner:

Home equity is the percentage of the home that you actually own.

For example, let’s just say that you have a mortgage on a $200,000 home. You’ve been paying your mortgage for five years, and you now owe the bank $100,000 until you completely own the home.

Assuming the value of your home and property has not changed in the past five years (which is unlikely), then your equity is the $100,000 that you’ve already paid off. Another way of expressing this is to say that you own a $100,000 stake in the house.

Until you’ve finished paying your mortgage off altogether, the bank technically still owns your home and can foreclose on the home if you fall behind on your monthly mortgage payments.

Determining Home Equity

The example that we gave above is a hypothetical situation. Realistically speaking, it’s very unlikely that your home’s value would remain the same over the course of several years. For instance, if you live in a rapidly developing city or town, then the value of your home should increase over time. This will give you more equity as time goes on.

The reason why homes are often considered to be “good” investments as opposed to automobiles is that they grow in value over time (unless there’s a financial collapse or a housing market downturn). This means that the longer you own a home, the more it will be worth. Conversely, a vehicle immediately depreciates as soon as you start driving it on the road.

For instance, if you got a home loan to purchase a $200,000 home and the home’s value increases to $300,000 over a five-year period, then your home equity has grown by 50%, not including the money that you’ve paid towards your mortgage.
So, other than looking at the market value of your home, how do you determine a home’s true equity? Let’s take a look.

Appraise The Property

If you want to know the true value of your home, then it’s essential to get it professionally appraised. Sure, you can look up a rudimentary number using an online website, but these numbers tend to be very different from the value of the home itself. This is why appraisals are key.

Once you hire an appraiser, they’ll come to your home and perform a full analysis. They’ll look at the quality of your home, weigh any improvements that you’ve made, search for any negative features (such as cracks in the foundation or a bad roof), and take plenty of notes.

After they perform their inspection, they’ll then weigh the value of the house itself against the value of other homes in the neighborhood, calculate annual inflation, and cross-reference their data with the MLS (multiple listing service) database used by real estate agents.

Once they’re finished, they’ll be able to give you a 100% accurate number for the value of your home. The documents they give you will also be signed and verified so that you can use them when applying for a home equity loan or trying to open a new line of credit.

Original Purchase Price

Although it typically doesn’t weigh as heavily on the overall value of your home’s equity, the appraiser will often take the original purchase price into consideration. This will serve as a sort of “baseline” and allow both you and the appraiser to see how much the home’s value has increased (or decreased) over time.

Cost Of Down Payment

The down payment that you initially put into the home is a big factor in the overall equity of your home. The larger your down payment is, the more starting equity you’ll have in your home. For example, if you put $20,000 on a $200,000 home, then your starting equity would be 10%, meaning that you technically own a tenth of your home the minute that you sign your mortgage agreement.

Building Home Equity

Now that you understand the concept of what equity is and how it works, it’s time to start getting into the finer details. Namely, how to build your home equity.

As we mentioned, your home’s equity should always be changing. As long as you continue to make your mortgage payment every month, maintain the quality and structure of the house, and perform the occasional renovation, then your home equity should steadily increase over time. As your home equity increases, you’ll gain more leverage to take out larger loans and receive access to better lines of credit.

Method 1- Pay Down The Mortgage

The most straightforward way to increase your home equity is to put more money towards the mortgage. With each passing payment that you make, you’ll have a slightly greater stake in the ownership of your home. For example, if you pay $1,000 per month on a $100,000 home, then your stake in the home will be 1% higher.

If you want to dramatically increase your home equity, though, you might consider making higher mortgage payments. Of course, you’ll always have your minimum monthly mortgage payment to make. However, there are no early payment penalties, which means that you can put additional funds towards your home loan whenever you have extra money to spare.

If you make a habit of saving extra money and paying it towards your mortgage, then you’ll gain more leverage on your home in a quicker amount of time.

Method 2- Increase The Property Value

Aside from paying off your home, though, there are also a number of other ways to increase your mortgage. One of the most common ways is to increase your property value. Your property value may increase due to renovations or additions to your property or it may increase due to natural factors such as a growing city, new jobs in the area, better schools, etc.

How To Increase Property Value Yourself

If you’re looking for a quick way to increase your equity, then you might consider performing a home renovation such as remodeling your kitchen, bathroom, or even building a new porch. The idea is that each renovation should be worth more than what you invested into the project.

Let’s say, for example, that you have a friend who’s a master carpenter. You pay them $5,000 for a new bathroom. As long as they do a great job and charge you a fair price, then that renovation alone could increase the value of your property by $7,500 or more!

As long as renovations are tasteful, in-style, and designed with quality and longevity in mind, then they’ll almost always be a positive investment.

Factors Out Of Your Control

In addition to making your own renovations to the property, though, there are a number of other factors that are out of your control that can increase the value of your home. Here are some positive events that can increase your home’s value:

  • A new arts or magnet school opening in your zip code.
  • A large company moving to your city.
  • Positive press on the news or a popular tv show being filmed in your city.
  • Roads being repaved or widened in your neighborhood.

That being said, there are also factors that can decrease the value of your property, including:

This is why it’s always a good idea to try to purchase a home in an area that you predict will see positive growth in the coming years. If you believe that your small town could turn into a booming city center in 10 years, then it’s almost certainly a good investment and you could end up doubling the money you spent on your home.

What Is Negative Equity and How Does It Happen?

Before we get into borrowing against your home equity, we should discuss a lesser-known aspect of home equity known as negative equity. Negative equity is sometimes referred to as an “upside-down home loan” and occurs when you owe more money to your home than it’s worth. This can happen due to several factors, such as:

  • Your home falls into disrepair.
  • The value of your neighborhood, city, or town goes down.
  • You have too many loans that leverage your home equity.
  • You have a federal tax lien that has been placed on your home.

Negative equity can also occur if there’s a crash in the housing market. This happened in the 2008 recession when investors drove the price of housing incredibly high and overvalued homes. The result was that many people purchased homes only to see the value of their homes get cut in half post-recession. This is why it always pays to do your research before you sign a long-term mortgage agreement on a home.

Borrowing Against Your Home’s Equity

By now, you should have a solid understanding of how home equity works, how it’s built, and how it can turn upside-down in the wrong market or given the wrong conditions. Assuming that you have positive home equity, though, it’s time to discuss how you can borrow against your home equity to get low-interest loans without having to apply for personal loans or credit cards.

Understanding Loan-To-Value Ratio

Before you apply to borrow against your home’s equity, you’ll need to know what your loan-to-value (LTV) ratio is. This number is calculated by dividing your current mortgage balance (how much more you owe) by the home’s appraisal value and then multiplying the result by 100. This will give you a percentage that displays how much of the home equity is in your favor.

For example, if you’ve paid $20,000 on a $100,000 home, then your LTV will be 20%.

Generally speaking, the lower your LTV is, the higher your interest rate will be on your home equity loan. Until your LTV is greater than 80%, lenders will usually require you to pay for Private Mortgage Insurance that ensures they’ll get paid even if you default on your home loan.

Once your LTV is 80%, it means that you own most of your home and present a lower risk to the lender. At this point, the interest rates charged by lenders will be decreased, and you’ll no longer have to purchase additional PMI insurance.

How To Borrow Against Your Home Equity

Once you’ve got your home’s value appraised and you’ve calculated your loan-to-value ratio, then you’re ready to go to a lender and start discussing your options to borrow against your home. Below are the three most common options that you’ll be able to choose from, depending on what you’re trying to do, your current mortgage status, and how much money you hope to borrow.

A Home Equity Line Of Credit (HELOC)

The best way to describe a home equity line of credit is that it’s like a credit card account with a limit that’s based on the value of your home equity. Typically, a HELOC will allow you to borrow around 80% of your equity value.

It will be treated as a revolving account that you can borrow money from and pay it back as needed. Like a credit card, your lender will charge you interest in the form of APR. This means that you’ll have to pay percent interest on any money that you have withdrawn and not paid back at the end of the year.

Most HELOC credit lines remain open for ten years at a time. If you have not paid back the balance at the end of the ten-year period, then you’ll no longer be able to withdraw funds from the credit line, and you’ll be required to pay everything you borrowed back before you’re allowed to open a new line of credit.

Home Equity Loan

A home equity loan is similar to a personal loan that’s given out to you based on your home’s equity. Unlike a home equity line of credit, however, a home equity loan is not a revolving account. Instead, you’ll receive a lump sum that’s given with a fixed or variable interest rate along with a repayment term.

If you are unable to keep up with your payments or default on your payments, then the lender reserves the right to foreclose on your home. This is one of the primary risks of home equity loans and why you should always have a solid plan to repay the loan before you take the loan out.

Cash-Out Refinancing

Cash-out refinancing is similar to refinancing but involves putting money in your hand. This option is usually available to those who have positive equity in their home. Instead of refinancing your existing mortgage (as your would with a standard refinancing program), you’ll apply for a new mortgage loan based on the most recent appraisal of your home.

This means that as long as your home’s value has increased in value since you originally purchased it, you’ll receive a far greater loan. With the money you receive, you’ll be able to pay off your original mortgage, and you’ll be able to keep the difference.

The only drawback is that now you’ll have to pay a higher mortgage. The benefit is that you’ll have access to quick cash, and you’ll still be left with a relatively high LTV ratio.

Why Borrow Against Your Equity?

Here are the top reasons why some people borrow against their home equity.

Home Improvement And Repairs

Perhaps you want to increase the value of your home, so you decide to borrow money to remodel your kitchen or redo the flooring. Houses may need a new roof every five years or so as well. This can cost several thousand dollars, which you may not just have sitting around. Borrowing against your equity for repairs and renovations is usually a smart idea because it increases your equity in the long term.

Investment Money

Suppose you want to start a business, invest in your children’s education, or create a diversified investment portfolio in the stock market. In that case, you may opt to borrow against your equity for one of these reasons. As long as you invest your money wisely, then you shouldn’t have a problem repaying the borrowed sum of money.

Debt Consolidation

If you’re falling behind on debts or you have high-interest loans that you’re struggling to pay, then you may consider consolidating these debts with a single home equity loan. You should always be very careful in these situations, though. If you’re not careful, you could just be trading one loan for another loan and risking your home at the same time.

What Are The Pros And Cons Of Borrowing Against Equity?

Here’s a quick overview of the pros and cons of borrowing against your home equity.

Pros

Cons

As long as you have a good LTV ratio, you can usually borrow more money than you would be able to with a standard unsecured personal loan.You’ll often have to pay more money upfront to get the loan. For example, you may have to hire an appraiser before your lender will give you a home equity loan.
You’ll often get a lower-interest loan, even if your personal credit isn’t the best.The collateral for the loan is your home. If you mess up and can’t repay the loan, then you could lose your home.
Borrowing against your home equity can be tax-deductible and can help you out when tax season comes around.Loan repayment terms are typically longer, so you may be locked into a long-term contract.