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What is home equity and how can you use it?

What we'll cover

  • The benefits of building home equity

  • How to calculate your home equity

  • How to borrow from your home equity

Scrolling through Zillow is a great way to get a sneak peek at the beautiful floor plans or not-so-stylish kitchen concepts of houses nearby. But even real estate websites can’t tell the full story of a property. And just like a home’s beauty is in the eye of the beholder, a home’s value lies in the equity of the homeowner.

So, what exactly is home equity? And why can’t you find it with a bit of online sleuthing?

Read on to find out.

Home equity defined

Home equity refers to the value of the portion of a property that you actually own. It’s your home’s current value minus what you still owe on your mortgage. As a homeowner, your home equity is a highly valuable asset. You can use it in a number of ways, but to do so smartly it’s important to understand how it works.

What's the value of building home equity?

You’ve probably heard that buying a home is an investment. That’s because the equity you build in your home can help you make other financial decisions down the line. For example, if you decide to sell your home, you can use the equity you’ve accrued to move into a bigger or better home — or you can put that money in savings. You can also tap into your equity while still living in your house, to fund other financial needs.

How to build equity

Your home equity can increase in different ways:

Make a down payment: The more you can put down initially means the more home equity you immediately have.

Your home’s value increases: If changes in the housing market cause your home’s value to jump, your equity will increase as well. Neighborhood features, like sidewalks or schools that cause property values in your area to grow, may also result in an increase. And typically, if you own your home for many years, it will appreciate over time — and you’ll accumulate more equity.

Make home improvements or renovations: Big makeovers, such as a new kitchen or master bath, can  boost your house’s value  the most. But even smaller projects, such as a new garage door or landscaping to add curb appeal, can increase your home’s worth.

How to calculate equity in your home

To calculate home equity, take the value of your home and subtract your mortgage balance.

Here’s an example: Your home is worth $200,000 and you made a 20% or $40,000 down payment. Then you took out a $160,000 mortgage to cover the rest. After your down payment, you have 20% equity in your home.

After five years of making mortgage payments, you now owe $130,000 for your mortgage. If the value of your home hasn’t changed, you’d have $70,000 or 35% equity in your home.

But say the value of your home has increased to $215,000. To calculate your equity, you subtract your remaining mortgage balance ($130,000) from the home’s current value to find you have $85,000 of equity, which is 39.5% of the home’s $215,000 value.

Borrowing from home equity

Having home equity is crucial because, in a way, it works like a savings account — but not one you dip into on a whim. As long as you own your house, you have equity that can be withdrawn to fund a college fund, pay down debt, or cover expenses in retirement. You can even use your equity to  finance home improvement projects.

So, what’s the main perk of tapping into your equity? When you borrow against yourself, interest rates are typically lower than  other types of personal loans . If you’re interested in drawing from your home’s equity, you can do so in one of three ways.

Home equity loan

Also known as a second mortgage, a home equity loan is a one-time lump-sum loan that you can use as you wish. You’ll work with your lender to pay it back in fixed monthly payments, typically over several years. . Home equity loans also tend to be fixed-rate, meaning that the interest rate will stay the same throughout the borrowing period. Keep in mind, having home equity doesn’t mean a home equity loan is a given. You have to get approved just as you would when applying for a first mortgage. Although Ally doesn’t currently provide home equity loans, it may be a viable option to pursue if you qualify and have at least 15 to 20% equity in your home.

Home equity line of credit (HELOC)

A HELOC can be a more flexible option that acts similarly to a credit card. As opposed to taking out a lump sum, HELOCs let you set up a line of credit that you can borrow from on an as-needed basis. These lines of credit often feature variable interest rates – meaning that the interest rate will fluctuate over time in response to market changes. The borrowed funds are typically repaid over the course of several years.

Cash-out refinance

When you elect for a  cash-out refinance , you essentially replace your existing mortgage with a new loan for an amount that’s more than what you owe. The difference in the two loans is returned to you in cash.

For example, say your home is worth $200,000 and you owe $80,000 on your mortgage. You can refinance that amount for $100,000 — and you’ll receive the $20,000 difference as cash.

The perk of going the cash-out refinance route is that it could potentially provide you with a lower interest rate than when you bought your home. You may also score lower interest rates than what’s offered for both home equity loans and HELOCs.

Note: It’s important to keep in mind that with any of these methods, you can’t always borrow against the full amount of your total amount of equity. For instance, to qualify for a cash-out refinance, lenders usually require you to retain at least 20% equity in your home — meaning you can usually only pull out up to 80% of your home’s equity.

Understand your assets

Tapping into your home’s equity can be a financially savvy way to access cash and make the most of your property investment. But it’s important to remember that it’s not free money and you will have to repay it, plus interest. And because your home acts as collateral, should you miss payments on your loan, your lender has the right to take your home via foreclosure.

As you make mortgage payments, don’t forget about the valuable asset you’re gaining by building up equity. With a strong credit score and equity in your home, you can achieve a new level of financial freedom.

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