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How Do Home Equity Loans Work

Did you know you can capitalize on your home’s equity to renovate your basement or add some major curb appeal to your house? Smart, informed borrowers can use the equity in their home to fund renovation projects or consolidate debt at a lower rate than you could with an unsecured loan.

We’ll show you how you can do it.

Main Takeaways: How Do Home Equity Loans Work?

  • Home equity builds as you pay off your mortgage. Once you have built up enough equity, you are able to borrow this back in order to fund other purchases.
  • People use their home equity for a wide range of purchases. These include home renovations, buying a new home, and more.
  • There are 2 main ways to borrow from your home’s equity. We explore this and more below.

What is Home Equity?

Home equity is the portion of your home that you own. Your equity increases over time if the property value increases or the loan balance is paid down. You may have purchased your home to own it, but if you borrowed money to purchase your home, then your lender also “owns” part of the property until you pay off your mortgage in full. 

Home equity is considered a homeowner’s most valuable asset. It’s important to understand how it works and how to use it as a financial tool.

Property Value

You’ll need to understand property value first in order to understand home equity. An appraisal will compare your property to other similar properties in the neighborhood which have recently sold.

This method is the most accurate for determining home value, but an appraisal can cost a chunk of change and might not be beneficial if you just want to run some preliminary numbers.

An appraisal would have been completed at that time the home was purchased. If the appraisal is not too old, the value might still be accurate unless your neighborhood real estate market has drastically changed. If an appraisal isn’t an option, an online search might yield an approximate home value.

A real estate tax bill sometimes assesses a fair cash value for the property that can also give you an approximate value.

Loan Amount

Your loan amount, or mortgage, is the dollar amount you owe your lender for the balance of your loan. It’s also called a secured loan. You don’t “own” your house until this security interest is satisfied and the mortgage is released.

The home is the collateral for the loan. If you don’t meet the obligations in the loan note and make payments as agreed, the bank can foreclose on your house, sell your property and apply the proceeds of the sale to the loan balance.

Putting it Together

Home equity is the part of the home you own, or that you’ve paid back to the lender. For example, your home may be valued at $200,000 with a loan balance of $150,000.

In this case, the equity you have in the home is $50,000: $200,000 – $150,000 = $50,000.

How to Use Your Home Equity

Home equity is considered an asset and part of the owner’s total net worth. You can take a partial or lump-sum loan or withdrawal of your home equity when you need it. There are several ways to utilize home equity.

Buy Your Next Home

The equity in your current home can be used as a down payment on a new home if you decide to move. This is commonly referred to as a bridge loan or a short-term loan that secures the remaining equity in your old home and is designed to be paid off with the proceeds of the old home’s sale.

Borrow Against Your Equity

You can borrow against your home’s equity at any time to fund home improvement projects or other expenses. Using your home equity as collateral will typically grant you a lower interest rate on financing, but it also means your asset is pledged to a lender and is no longer considered an asset. 

Fund Retirement 

A reverse mortgage can allow you to spend down your equity in retirement years, but it also might mean that your heirs will be left with debt instead of an asset. 

Types of Home Equity Loans

There are several types of home equity loans you can tap into, including a home equity loan, home equity line of credit (HELOC), 

Home Equity Loan

A home equity loan is a lump sum loan that means that on closing, your lender will distribute the entire loan amount to you. These loans are typically fixed-rate loans and terms are shorter than a first mortgage so you can minimize exposure risk and pay the loan off in a reasonable amount of time.

From a budgeting standpoint, this is a better option if you need a large sum of money all at once. Interest must be paid on the full amount but may be preferred for large one-time cash needs such as a home renovation, debt consolidation or college expenses.

Home Equity Line of Credit (HELOC)

A home equity line of credit (HELOC) allows you to pull funds out as needed and only pay interest on what you’ve borrowed.

A HELOC functions similarly to a credit card. You have a maximum credit limit and can borrow money in increments and pay them down as you go. The balance can fluctuate depending on what is borrowed and paid. Most HELOCs are variable rate loans tied to an index rate plus a margin. 

For example, a HELOC might be tied to the Wall Street Prime Rate (now 5.5%) plus a margin of 0.5%, which makes the rate 6%.

As the Prime Rate increases, the rate applied to the balance and your payment also does as well. HELOCs typically have a floor and ceiling rate that dictates that the rate can only go so low or so high. A variable option in a rising rate environment might not be right for your needs. 

Do you plan to fund many small projects and can pay down the balance in between projects? This might be a preferred option.

How to Build Equity

You can build equity by increasing your property value and reduce debt.

Increase Property Value

There is no way to have control of whether the housing market increases or decreases. However, if the home values in your market happen to increase over time, then your equity will increase as well. This can happen in attractive neighborhoods and growing towns with robust economies and employers.

Updating kitchens and bathrooms, improving landscaping and upgrading to energy-efficient options can pay off and increase the value of your home. Keep in mind that these improvements will cost money upfront and are not guaranteed to increase the value. The home value will not increase dollar for dollar what you spent on improvements. 

Simple routine maintenance, such as fixing broken fences, painting decks and repairing torn screens can also keep a house in working order. Routine maintenance might not increase your home’s value, but it prevents the value from decreasing.

Reduce Debt

Any way you can reduce debt will increase your home’s equity. You can do this by: 

  • Make your monthly payments: Making regular payments decreases your loan amount and increases home equity with every payment.
  • Choose shorter terms: Shorter loan terms allow you to pay down debt faster and increase equity.
  • Make extra payments: You can make extra payments on a mortgage loan, which can be applied to the principal balance and reduces the loan balance faster. Just be sure your lender doesn’t require you to pay a prepayment penalty if you do pay your loan off early.

Your Own Equity Savings Account

The best way to look at home equity is to view it as a savings account, or a valuable asset which grows over time. If the loan balance continues to decrease as you make payments, your equity increases.

Then, once you identify your needs, whether you’re after a trip you’ve always wanted or a beautiful new patio, you can harness the power of your home’s equity and get a home equity loan or a HELOC.

If you’re looking for more home buying resources, check out Benzinga’s guide on the best ways to save money in order to fund a down payment or renovation.