Most buyers today rely on mortgage loans to purchase the homes in which they live. That's because most don't have hundreds of thousands of dollars in cash to tap to buy a residence. The goal once homeowners take out a mortgage loan is to build equity in their homes. Equity can build in two ways: Homeowners can pay off their mortgage loan's principal balance, or they can luck into it by watching as their home increases in value.
Your equity tells you how much of your home you actually own. You figure it by subtracting the amount of money you owe on your mortgage loan from the current market value of your residence. If you owe $150,000 on your mortgage loan and your home is worth $200,000, you have $50,000 equity in your residence. Equity is not always positive. You could be underwater on your home -- meaning you owe more on your mortgage than your home is worth -- if your home's value has fallen since you purchased it. If you owe $180,000 on your mortgage loan and your home is now worth just $160,000, you have negative equity of $20,000, meaning that you are underwater.
You can build equity by making your mortgage payments on time. However, this isn't always the fastest way that equity grows. In the first several years of paying off your mortgage loan, the majority of your monthly mortgage payment will go toward the interest on your mortgage loan, with only a small portion going to reduce its principal balance. If you want your equity to grow quickly during the early years of paying off your mortgage loan, you'll have to hope that your home increases in value. For instance, if you owe $180,000 on your mortgage loan after living in your residence for one year, your equity would jump to $20,000 if your home's value has increased during that year to $200,000.
The amount of equity in your home is important because you can borrow money against it to pay for such expenses as a child's college education or a major home-improvement project. Lenders will give you home equity lines of credit or home equity loans depending on how much equity you have in your home. If you have equity of $80,000, for example, lenders might be willing to give you a home equity loan of $50,000 or a home equity line of credit of $60,000, depending on the lender.
These types of equity loans are not the same. A home equity loan is like a second mortgage loan you get in one lump-sum payment. You repay it in monthly installments with a fixed or variable interest rate, much like any other mortgage loan. A home equity line of credit is more like a credit card. Your lender gives you a line of credit with a maximum that is tied to the amount of equity in your home. You only pay back what you borrow. For instance, if you have a home equity line of credit of $80,000 and you borrow $15,000 for a kitchen remodel, you only have to pay back the $15,000 -- with interest -- that you borrowed. The interest rates on home equity loans and home equity lines of credit are usually lower than those attached to credit cards.
Equity plays an important role, too, when you want to refinance your existing mortgage loan into one with lower interest rates. Most lenders require that you have at least 20 percent equity in your home before they'll approve you for a conventional mortgage loan. If you owe $150,000 on a home worth $250,000, you'll have 40 percent equity in your home -- figure equity percentage by dividing your total equity by your home's market value -- enough to qualify for a refinance. However, if you owe $240,000 on that home worth $250,000, you'll have equity of less than 1 percent, not nearly enough for most traditional mortgage lenders.
Don Rafner has been writing professionally since 1992, with work published in "The Washington Post," "Chicago Tribune," "Phoenix Magazine" and several trade magazines. He is also the managing editor of "Midwest Real Estate News." He specializes in writing about mortgage lending, personal finance, business and real-estate topics. He holds a Bachelor of Arts in journalism from the University of Illinois.