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How Does Home Equity Work

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Every homeowner with a mortgage should know what their home equity is. But not everyone understands how it works. How is equity calculated, how is it grown, and how can it be used? Clearing up some of these questions can be the first step toward recognizing the potential of owning (and investing) in your home, helping you realize your options when it comes to renovating or selling your home.

So how does home equity work and how might you get the most out of it?

Calculating It

To start with, home equity is the appraised value of your home minus the outstanding balance on your mortgage. In other words, it’s the amount you’ve already paid into your home plus the real value of your home as it increases over time.

Say your home is valued at $250,000 and your current mortgage balance is $170,000, then your equity stands at $80,000—the difference between those two figures. You can find a rough estimate of your home value through websites such as Zillow or Redfin, or use Rivermark Community Credit Union’s online home equity calculator.

In order to determine the exact value of your home, you should consult a professional home appraiser, who will look at a number of factors, including home improvements you’ve made, the area where your home is located, and the condition of your property. And many of these factors are within your control, such as landscaping your property, making additions to your home, and installing new appliances to increase the overall value.

Growing It

Besides making home improvements to increase the value of your home, you can also grow your equity over time through a number of smart financial moves.

If you’re looking to buy a new (or first) home, making a sizeable down payment on your house can start you off in a better position. For instance, if your down payment is 20 percent or more of the total purchase for your home, then your mortgage is lower than if you had made a 15 percent down payment.

Using the same example as above, if you purchase your home at $250,000, and your down payment is 20 percent ($50,000) of that, then you end up with a mortgage of $200,000. That down payment is your starting equity. Over time, as the value of your house increases while you chip away at your mortgage balance, your equity likewise increases.

Say you’ve lived in your home for 5 years, making consistent payments on your 30-year mortgage plan. Your mortgage balance has lowered from $200,000 to $166,000 (excluding the interest). The value of your house has increased from $250,000 to $320,000. Which means your equity stands at $154,000.

Having a consistent financial strategy in place to pay back your mortgage in a timely manner and/or overpaying your mortgage at certain times (as allowed by the lender) are both effective ways of helping you lower the balance on your outstanding mortgage.

It goes without saying that the longer you live in your home and continue to make payments, the lower your outstanding mortgage balance, and as home values generally increase over time, the greater your home equity, eventually making you “equity rich.”

Using It

As a homeowner, you can tap into the equity you’ve accrued over time in order to make large purchases, invest in your home, or prepare your home for sale. If you’re looking to remodel your bathrooms, purchase a new car, consolidate debt, cover your child’s college expenses, build an emergency fund, or upgrade to an even better home, then your home equity can be a valuable resource.

Taking out a home equity loan or home equity line of credit (HELOC), which can be referred to as “second mortgages,” allows you to tap into that equity. However, each comes with its own pros and cons.

To start with, you won’t get the exact amount your equity represents. Most lenders—and they don’t need to be the same lender that issued your mortgage—will provide loan options allowing you to borrow 75 to 90 percent against your home equity, depending on how much you qualify. Some lenders allow you to borrow up to 95 percent. Factors such as your credit score, income, financial history, and current outstanding debt help determine how much of your home equity you can borrow against.

Both options also require you to put up your home as collateral, just as your mortgage. Thus, taking out a home equity loan or HELOC without a secure financial strategy for paying back your second mortgage could result in missing payments (leading to foreclosure) or taking out additional loans to cover your existing debt. That’s why it’s important to carefully weigh the risks of either a home equity loan or a HELOC and consult a financial assistant.

Home Equity Loan vs. HELOC

Home equity loans and HELOCs tap into your home equity differently. A home equity loan provides a one-time lump-sum loan that can be paid back to the lender over a fixed period of time and at a fixed rate. Taking out a home equity loan can help you cover the costs of house repairs or home improvement (funds for which can be tax-deductible), making a one-time investment. And by having a fixed payment plan, you can manage your finances more predictably.

A HELOC, on the other, being a line of credit, allows you to tap into your home equity at different times and for different amounts, functioning similarly to a credit card, but with much lower interest rates. A HELOC can be a wise choice for making long-term, smaller, recurring investments, such as covering your child’s college tuition. But while you pay back only what you borrow in most cases, interest rates vary, and your borrowing limit and home equity also change, leading to less predictable payment amounts.

Making It Work for You

Whether fixing your dream home, investing in your child’s education, covering medical bills, or consolidating debt, home equity can be a valuable resource you can tap into. Understanding how to grow equity and how to use it will help you make smart, sound decisions to improve and sustain your financial wellness. Credit unions can help guide you in making these decisions and provide you with options for accessing your home equity.

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