What is Home Equity?
Learn Why the Equity in Your Home Matters
Home equity represents the value of your home minus the amount you still owe on your mortgage or home loan. Initially, your home equity is equivalent to your down payment. For example, if you purchase a home for $250,000 with a $25,000 down payment, your starting equity is $25,000. Over time, this equity can grow and become a valuable financial asset.
How Can Your Home Equity Increase?
Your home equity can increase in two key ways: by paying down your mortgage principal and through appreciation in your home's value.
- Paying Your Mortgage: As you make mortgage payments, part of each payment reduces your principal balance. While a large portion of early mortgage payments goes toward interest, over time, more will go toward reducing your principal and building equity. Making additional payments, such as an extra mortgage payment each year or opting for bi-weekly payments, can help you pay off your loan faster and build equity sooner while saving on interest.
- Home Appreciation: Your equity also grows as your home’s market value increases. For instance, if you bought your home five years ago for $250,000 and the current market value is $300,000, that $50,000 increase becomes part of your home equity. Keep in mind, however, that if housing prices fall, your home equity may decrease accordingly.
How Can You Calculate Your Home Equity?
To calculate your home equity, start by estimating your home’s current market value. Websites like Zillow or Redfin can give you an idea, but for a more accurate valuation, you may need to hire a professional appraiser (which comes with a fee).
Next, subtract your remaining mortgage balance (found on your latest mortgage statement) and any other home loans from the estimated market value. This calculation gives you an estimate of your home equity.
Example Calculation:
- Current fair market value: $275,000
- Current mortgage balance: - $150,000
- Current balance on a second home loan: - $25,000
- Estimated home equity: $100,000
Why Does Your Home Equity Matter?
Your home equity represents a significant financial asset that can benefit you in several ways:
- Removing PMI: If you have a conventional mortgage and are paying private mortgage insurance (PMI), keeping track of your equity is important. Once your equity reaches 20%, you may be eligible to cancel your PMI, which can save you money on your monthly payments.
- Accessing Cash: You can borrow against your home’s equity to finance major expenses, such as home improvements, education costs, or debt consolidation, through a cash-out refinance.
- Refinancing Opportunities: A strong equity position can also help you secure better refinancing options. Lenders prefer borrowers with a lower loan-to-value (LTV) ratio and may offer lower interest rates or better loan terms.
What is "Tappable Equity"?
“Tappable equity” refers to the portion of your home equity that you may be able to borrow against. Most lenders require homeowners to retain 20% equity in their homes, meaning you can’t typically access your full equity. Here’s a sample calculation to determine your tappable equity:
Example Calculation:
- Current fair market value: $375,000
- Current mortgage balance: - $225,000
- Estimated home equity: $150,000 (40% of the home’s value)
- Maximum new mortgage balance: - $300,000 (to retain 20% equity)
- Estimated tappable equity: $75,000 ($300,000 - $225,000)
In this example, you may be able to access $75,000 in cash through a cash-out refinance.
What is a Gift of Equity?
A gift of equity occurs when a friend or family member sells you a home for less than its market value. The difference between the sale price and the market value becomes the "gift" of equity. This gift doesn’t involve a cash transfer; instead, it’s reflected in the property transaction.
If you’re securing a conventional mortgage for the purchase, a gift of equity might help you avoid paying PMI if your equity surpasses 20%. Some lenders also allow a gift of equity to be used toward the down payment on a home.
Home sales involving a gift of equity usually require an appraisal and documentation that verifies the relationship between the buyer and seller and outlines the gift’s terms. Additionally, closing costs still apply, and the transaction may be subject to gift taxes—so it’s wise to consult a tax professional.