It’s okay to not have an answer to the “What is home equity?” question—this guide will clear up any confusion and give you the knowledge you need to get the most out of your home.
Chances are, if you’re a homeowner, you know what home equity is, even if it isn’t talked about much during those steps to buying a house. If you’ve heard the term but don’t know what is home equity, pay attention: Home equity is essentially your home’s value once you factor in how much you still owe on your mortgage loan.
Even if you know what home equity is, can you confidently say you know how a home equity loan or a home equity line of credit (also called a HELOC) works? If you can’t, here’s a guide on what it is and how you can use home equity for everything from college loans to home renovation projects. (Unfortunately, it can’t really help you cover those pesky cost of selling a house.)
What is home equity?
When you purchase a home, you don’t usually pay with cash. Most folks make a sizeable down payment on a house and commit to monthly payments toward a 15- or 30-year mortgage. On day one of your home sale, your home equity is equal to the amount of that down payment. The down payment is the only portion of the home you’ve actually paid for.
As time goes on, you earn more and more equity with each payment you make toward your loan. Any amount paid against the principal of the mortgage loan—not interest—is your home equity. Figuring out how to pay off that mortgage early can even help boost your home equity.
Banks will let you borrow against that amount and use the cash however you see fit. These home equity loans are relatively easy to obtain and come with low interest rates compared to other traditional loans and lines of credit.
“At its core, it provides a very low cost, flexible way for you as a client to borrow against the home equity in your home,” says Michelle McLellan, a product management executive with Bank of America.
Home equity line of credit vs. home equity loan
There are two ways you can borrow against your home equity. The first is through a standard home equity loan. These loans are issued in lump sums with payment plans up to 30 years, which you’ll pay while paying your original mortgage. The interest is calculated at the time you withdraw the loan, and you get the cash right away.
“Most banks will offer a 10-year draw with a 20-year payment,” McLellan says, meaning that you can use the cash for a decade before you have to begin paying it back.
The second option is a home equity line of credit, or a HELOC. A HELOC functions more like a credit card, allowing you to purchase and pay for things up to a certain total amount. You only pay interest on the purchases you make, and you don’t have to worry about paying back a predetermined sum.
With either type of borrowing against home equity, the terms and interest rates are usually pretty good.
“The reason is that you’re putting up a part of your house as collateral,” says Jeff Tucker, an economist with Zillow. “If you default long enough they can take your home, so it’s a safer line of credit for the bank.”
What can you use a home equity loan or home equity line of credit for?
Anyone looking at bathroom remodeling costs or considering a new fence knows that major renovations can cost an arm and a leg. (Just take a look at a typical kitchen remodel cost.)
“The majority will use [that money] for home renovations or in case of emergency, or a second home,” McLellan says.
But there are no rules on how you have to use the cash you borrow against your home’s equity.
“Some use it on elder care, some use it to buy a vacation property,” McLellan says.
However that money is used, most folks find that home equity loans are a more affordable option compared to traditional loans and credit cards.
“Good uses could be paying for college tuition, or another big lump sum bill you may want to cover for your kids,” Tucker says. “Many people may find they can get better rates on this kind of credit than on, say, a student loan.”
Want to see what kind of loan you qualify for? Try Zillow’s home equity calculator to find out.
Home equity loan requirements
You can qualify for a home equity line of credit starting the day you purchase your home. There is no waiting period in terms of when you’re able to apply for these loans, and the amount you qualify for will always depend on how much you’ve paid toward your loan, McLellan says. In other words, your loan can’t be larger than your home equity.
Following the financial crisis, banks began capping home equity loans and HELOCs at 80 to 85 percent of a homeowner’s equity. This amount ensures that you don’t ever owe more on your home equity loan than you do on your original mortgage.
“Eighty percent has long been the tipping point,” Tucker says.
If you apply for a home equity loan or a home equity line of credit through the same bank that financed your original mortgage, you could see some perks.
“If you’re a customer, we’ll give you a relationship discount,” McLellan says. Also, paying the loan off is easier if it’s all done at the same bank, through the same app or account.
Depending on your bank, you may have to pay fees to access equity, so don’t be afraid to shop around.
Before you’re approved, your bank will want to have an appraisal done on your home. This step is required regardless of when your last appraisal was completed. And banks won’t rely on information provided by sites such as Zillow, Tucker says. Typically, you’ll have to pay for this service and await the results before a bank will decide what your total home equity loan will be.
In an emergency, though, you can expect to get approval for your loan rather quickly, within the span of 30 to 35 days, McLellan says.
Home equity loan mistakes and pitfalls
While it might seem like a home equity loan or home equity line of credit is a simple and affordable way to make home improvements, pay off other debts, or use in the case of an emergency, there are pitfalls.
That’s because with every loan, there is still the possibility of defaulting.
“If you’re sure your income will continue so you can pay it back, it’s a safe option,” Tucker says. “But to the extent that none of us has a crystal ball, we can’t be certain we’ll have the same employment we did last year.”
And while safeholds are in place to prevent foreclosures (which happened en masse during the financial crisis), the market still plays a role in whether you’ll be stuck with a home for which you owe more than it’s worth.
Approach this type of loan the way you would any other, and consider whether you’ll be able to pay it and whether the potential consequences are worth the risk.