Even if you’re paying off a mortgage loan, you may still own a portion of your home’s value – its equity. You can use your home equity to collateralize a loan, or you can let it continue to build until you pay your mortgage loan in full. You can allow your home equity to build gradually over time as you continue to make your mortgage payments, or you may see an even faster increase in its value as a result of rising market prices or home improvements you make.
What Is Home Equity?
Home equity is the portion of your home’s worth that is left over after you subtract what you still owe on your mortgage loan from its appraised value. For example, if your home’s appraised value is $200,000 and you still owe $150,000 on your mortgage loan, your equity is $50,000. This is an example of positive equity, which is what you want to have. But if your home’s appraised value is less than your mortgage balance, you have negative equity. For example, if your home’s appraised value is $180,000, but you still owe $200,000 on your mortgage loan, your equity is minus $20,000. Negative equity may be the result of purchasing a home before real estate prices plummet or using your home as collateral for a loan during a market decline. You can continue to build equity in your home even if it currently has a negative equity balance toward the goal of building equity to a positive balance.
What Does It Mean To Build Equity?
You build equity in your home as you pay down the principal balance of your mortgage loan. The “principal” is the portion of your loan that represents the actual amount you borrowed to purchase your home. In addition to this principal amount, you’re also paying interest on the loan. Only the portion that you pay toward principal increases your equity; not the amount you make toward interest payments. In the early years of paying a mortgage loan, you’re paying very little toward the principal amount. Most of your monthly mortgage payments go toward reducing the interest balance of the loan. But as you continue to make payments, the amount you pay toward principal increases while the amount you pay toward interest decreases, through a process called amortization. As you continue to reduce the principal balance you owe, you’re building equity.
You can build equity faster by making additional, voluntary payments toward the principal balance. Check with your lender to make sure these additional payments will be applied toward the principal balance. Most mortgage loans do not impose a prepayment penalty if you're able to pay your loan before its maturity date but ask your lender about this too.
Using Home Equity
As you build equity, you’re essentially building a savings or investment account of sorts. You can simply leave the equity alone, or you can put it to work for you by borrowing money using your home equity as collateral. You can use this money for many things such as making home improvements, paying for education costs and financing debt-consolidation loans. You can even pay for luxury items, like a new car or a vacation, with a home equity loan. Typically, the amount you can borrow against the equity in your home is a maximum of 85 percent. Lenders will also consider your income, your other debts and your credit history as additional factors for approving or denying a home equity loan.
The Federal Trade Commission advises consumers to proceed with caution when considering a home equity loan. If you default on the loan, you could lose not only your home equity but your home itself.
What Is a Home Equity Loan?
A home equity loan is not the same as your home mortgage loan; it’s a different kind of loan that’s secured by your home’s equity. You make payments on your home equity loan just as you do for your home mortgage loan, but the terms may be different. In fact, each prospective lender may offer different terms, which include the length of the loan, the interest rate and fees. The Federal Trade Commission recommends shopping different lenders as you consider a home equity loan so you can find the best deal for your financial situation that meets your goals. Prospective lenders for home equity loans include banks, savings and loans, credit unions and mortgage companies.
- Federal Trade Commission: Using Your Home as Collateral
- Federal Trade Commission: Home Equity Loans and Credit Lines
- Consumer Financial Protection Bureau: How Does Paying Down a Mortgage Work?
- Consumer Financial Protection Bureau: What is a Prepayment Penalty?
- Consumer Financial Protection Bureau. "What Is a Home Equity Loan?" Accessed July 12, 2020.
- Consumer Financial Protection Bureau. "What Is a Second Mortage Loan or Junior-Lien?" Accessed July 12, 2020.
- Consumer Financial Protection Bureau. "Mortgages Key Terms." Accessed July 12, 2020.
- Federal Trade Commission Consumer Information. "Reverse Mortgages." Accessed July 12, 2020.
- Federal Trade Commission Consumer Information. "Home Equity Loans and Credit Lines." Accessed July 12, 2020.
- Experian. "What Credit Score Do I Need to Get a Home Equity Loan?" Accessed July 12, 2020.
- Consumer Financial Protection Bureau. "What You Should Know About Home Equity Lines of Credit?" Page 3. Accessed May 21, 2020.
Victoria Lee Blackstone was formerly with Freddie Mac’s mortgage acquisition department, where she funded multi-million-dollar loan pools for primary lending institutions, worked on a mortgage fraud task force and wrote the convertible ARM section of the company’s policies and procedures manual. Currently, Blackstone is a professional writer with expertise in the fields of mortgage, finance, budgeting and tax. She is the author of more than 2,000 published works for newspapers, magazines, online publications and individual clients.