What Is Equity in Real Estate?

Homeownership comes with major perks. It allows you the freedom to create your own unique living environment and an increased level of financial stability. It also offers you the ability to build equity in your home.

This article will outline everything you should know about home equity, how to build it, and the best way to use it.

Why do we buy real estate?

Homebuyers are driven by several factors, including a desire for independence, control, and self-expression, which can be summarized in an acronym known as U.P.T.E.E., which refers to a property owner’s bundle of rights.  

These rights are as follows:

• Use: The right to use a property for any purpose. In practice, this means for any lawful purpose, subject to things like zoning rules, HOA rules, permits, and other legal restrictions.
• Possess: The right to live on the property and keep others out.
• Transfer: The right to transfer the property by sale or by gift.
• Encumber: The right to borrow money and use a property to secure the loan.
• Enjoy: The right to peace, quiet, and enjoyment on the property.

With these rights comes the possibility to build value, or home equity, in your home. That equity allows the homeowner’s right (and defined by the right to “encumber”) to borrow money against the property to secure a loan.  

What is equity?

Equity is the difference between the amount of money that you owe the mortgage lender and the amount of money that your home is worth. 

A more complete way to think about it is:

‍Equity = market value − what you owe on all liens secured by the property (for example, your mortgage plus any HELOC or home equity loan).

Over time, you will make mortgage payments on the house, reducing the loan’s principal balance, thus building equity by increasing the percentage of the home you actually own.

How does equity work?

If you were to purchase a home worth $300,000, for example, using a $30,000 down payment, you would automatically have $30,000 of equity at closing. 

As you make each payment toward your mortgage, your loan balance will decrease. This builds more equity as long as the value of your home remains the same or increases over time.

Once you pay 100% of your mortgage, you will have 100% equity.

Sometimes, home prices can drop sharply, and a homeowner may owe the lender more than what the home is actually worth.

Using our example, if the home’s value dropped to $200,000 and you still owed $240,000, the loan would be considered “underwater,” or you would have “negative equity.”

How do you build equity in your home?

There are several different ways to build equity in your home, including:

• increasing the down payment you put on your home at the time of purchase.
• increasing your mortgage payment amount or making additional payments
• refinancing and shortening the term of your loan.
• investing in home improvement and remodeling projects to increase the home’s value.

What is the best way to tap the equity of a home?

You can tap into the equity of a home you have built as a convenient way to borrow money. Because the loan is secured by your home, home equity borrowing can sometimes be lower-cost than many unsecured loans—but rates and qualifications vary by lender, credit score, and market conditions.

Depending on a person’s credit score and financial history, a lender will generally want to see a combined loan-to-value (CLTV) ratio around 80%–85% or less. CLTV looks at what you owe on your first mortgage plus the new loan, divided by your home’s current value. That’s why most homeowners can’t borrow “the full value” of the home—lenders usually cap how much you can borrow based on your home’s value minus what you already owe.

Most home equity loan terms will range between five and 20 years, but borrowers can take 30 years to pay a home equity loan depending on the lender and product. On longer-term loans, a significant amount of a borrower’s monthly payment can go to interest in the beginning, which is why it’s important to compare the total cost of the loan—not just the monthly payment.

It can take years for a homeowner to reach a 20% equity threshold, but the timeline depends on the down payment, extra principal payments, loan type, and how home values change. Some homeowners reach it quickly, while others may take longer.

Common Reasons People Use Home Equity

Covering business expenses

Many small business owners will tap into home equity and use the money to help grow their business. The move is particularly advantageous when avoiding higher interest rates associated with a small business loan.

Finance emergency expenses

Emergencies happen. Most financial advisors suggest having an emergency fund covering six months of your living expenses. But that’s hard for most people to do. A home equity loan may be your best choice when faced with an emergency and no way to get the finances you need. 

Consolidate your debt

Home equity loans can be great tools for consolidating high-interest debts at lower interest rates. You can use this method to help you pay off personal debts like credit cards and car loans. 

Pay for college

If the lender approves, you can use your home equity for covering college expenses. Although student loans are usually your best bet for paying college expenses, home equity loans can sometimes offer better low-interest options. 

Finance home improvements

Home equity loans are most commonly used for home improvement projects because, in addition to making your home more livable, comfortable, and desirable, the upgrades that you make can potentially raise the house’s value, thus building more equity. It can really be a win-win. 

Home improvement is also the most common situation where home equity loan/HELOC interest may qualify for a tax deduction—when the funds are used to buy, build, or substantially improve the home that secures the loan.

Final thoughts on the equity of a home

There is no doubt that most Americans who can purchase a home do so to put a roof over their heads. Still, through equity, homeownership truly becomes an investment. 

A home equity loan (or HELOC) can be a valuable tool, but rates vary and should be compared carefully. Also, tax benefits are not automatic—interest is generally deductible only when the borrowed funds are used to buy, build, or substantially improve the home that secures the loan (and other IRS limits/rules apply).

They just have to make sure they have a steady income that can repay the loan.