What Is Home Equity And How It Works

home equity what is it and how it works explained

One advantage of buying a house is the ability to accumulate equity in it. You may then use that equity to finance a significant kitchen renovation, home improvements, the repayment of high-interest credit card debt, or even your children’s college expenses.

Additionally, you may utilize your home equity to make improvements before you sell it.

You could be able to sell a refurbished property for a lot more money than you would normally obtain, depending on the market. But what is home equity precisely, and how does it operate?

The value of a homeowner’s financial stake in their house is known as home equity. In other words, it is the market worth of the physical property, excluding any debts affixed to it.

Here is a brief explanation of the fundamentals of home equity, including its importance.

What is Home Equity?

Home equity is the sum of your remaining mortgage debt and your home’s current market value. If your house is worth $150,000, but you still owe $100,000 on your mortgage, you have $50,000 in equity.

As the homeowner makes payments toward the mortgage balance or as the property value rises, the equity in the property grows. Real property value is another name for home equity in economics.

Because the equity in the property secures the funds, the interest rate for borrowing based on home equity is often lesser than that on credit card payments and personal loans. So your home’s equity might be a wise source of money.

  • Additionally, interest paid on such borrowing is typically tax deductible if the money is put toward house improvements.

How It Works

The part of a property’s present worth that the owner currently owns is known as home equity. When you put a down payment on a home when you buy it, you start to build up equity. After then, when mortgage payments are made, a homeowner’s equity keeps increasing.

This is because a certain amount of each payment is designated to lower the remaining principal balance that you still owe.

There are two ways for homeowners to build equity in their homes. They buy equity with their deposit and the principal amount of any mortgage payments they make. When the property’s value rises, they also win from an increase in equity.

Investors often seek properties that will improve in value over time, resulting in an increase in the equity in the property and, ultimately, returns on their capital when the property is sold.

Benefits of Home Equity for Homeowners and Investors

Home equity has a lot of benefits you can take advantage of as a homeowner. These benefits include:

  • Decreased Interest Rates

You may borrow a particular amount with a home equity loan and repay it over a predetermined period. Home equity loans often include closing expenses, additional fees, and relatively low fixed interest rates that range from 3 to 5 percent each.

Due to the utilization of your property as collateral, these loans have lower interest rates than unsecured loans.

You might be able to obtain an even lower rate if you have excellent credit. Borrowing against the equity in your house may be a valuable option to consolidate higher-interest debt, such as credit card debt, because of the low-interest rates on most home equity loans.

  • Scalable Term Periods

Home equity loans often feature more accommodating twenty to thirty-year payback terms in addition to lower interest rates. The loan repayment process is the same as it is for other loans.

  • Preferable to Refinancing

One practical way to pay off other debt and maybe get cash is to refinance your house. However, you should only choose to refinance if you intend to live in your home for a minimum of 12 to 18 months.

Home equity loans provide a greater rate of cash-out possibilities than refinancing, which may be more beneficial while upgrading or taking on another significant home project.

This is one of the benefits of home equity loans over refinancing.

  • Increased Home Value

Using the equity in your home to make significant renovations, like a kitchen or bathroom makeover or a new roof, will not only improve the standard of living for you and your family while you live there, but it’s also a wise investment for the long-term value of your house.

Also, you may utilize your home equity to make improvements before selling it. You could be able to sell a refurbished property for more money than you would normally obtain, depending on the market.

Secondly, it could sell more quickly since the house has been improved or renovated. No matter what, a refurbished home will generally appeal to more homebuyers because the bulk of the labor-intensive work would have been done before they moved in.

How to Increase or Build Home Equity

Once you are aware of the advantages of home equity, you might wish to concentrate on increasing it.

You may increase your home’s equity in various ways, such as:

  1. Put A Significant Down Payment On It

Making a sizable down payment is the quickest method to develop equity. The more equity you have in your house right away depends on the size of your down payment. Consider this analogy:

  • Let’s say your house is worth $200,000.  If you put $5,000 down, your mortgage balance will be $195,000. You are left with $5,000 in equity. For a property worth $200,000, a $25,000 down payment leaves you with a debt of $170,000. It’s more amazing to have $30,000 in equity than $5,000.

Understanding how you’ll create equity in your house begins with determining how much you can put toward your down payment. In other words, if you start with a significant amount, you can increase your home equity drastically.

  1. Pay Attention to Paying off Your Mortgage.

Every mortgage loan you pay will be partly applied to the loan’s principal. The balance will often be used to pay interest, real estate taxes, and homeowner’s insurance.

Be aware of the type of mortgage you’re getting. For instance, to build your equity consistently, avoid an interest-only loan. Payments for that go toward interest alone. No principal is paid off until a single lump sum is required.

Make every mortgage payment and try to pay more than the minimum amount required. Go for a mortgage that allows more percentage for principal reduction.

Less of your initial mortgage payment will be used for principal reduction, and more will be applied to interest when you initially start making payments.

  1. Stay in Your House

If the value of your home rises, you’ll build equity. No property’s worth will necessarily improve, but if you live in your home for a long time, your chances of doing so will be higher.

If you want to see your home’s worth increase enough to increase your equity, you should plan to live there for at least five years.

What is Home Equity Loan

A home equity loan is a one-time payment that you make against the value of your house. Most lenders will allow you to borrow up to 80% to 85% of the equity in your home, which is the worth of your property, less the outstanding mortgage balance.

These loans have set interest rates and often take five to thirty years to pay off. A lender may seize your property if you default on a home equity loan since your home acts as collateral.

Several banks, credit unions, and internet lenders provide home equity loans. These funds are available for various uses, such as debt relief, home renovations, and higher education expenses.

Your financial status, the amount of equity you own, and other considerations will all affect how much you may borrow.

Calculating the Equity of Your Home

By dividing your debt by the value of your house, you may determine how much equity you may be able to borrow.

  • For example, you owe $100,000 on a $300,000 property. $100,000 divided by $300,000 equals 0.30, or a 30% loan-to-value (LTV) ratio.

You now have a 30% ownership stake in your house. To determine if you could be eligible for a home equity loan, compare that amount to the maximum LTV ratio set by your lender.

Next, determine your borrowing capacity by multiplying the value of your property by the maximum LTV ratio allowed by your lender and deducting the outstanding balance on your mortgage.

Let’s say your lender permits you to borrow up to 80% of the value of your property. In this case, $300,000 multiplied by 0.80 would equal $240,000.

The highest amount you might be able to borrow is $240,000 minus your mortgage debt ($100,000), which equals $140,000.

Pros and Cons of Home Equity Loan


  • Interest rates that are lower than those for unsecured debt like credit cards and personal loans
  • High borrowing restrictions
  • Monthly payments are fixed
  • Taxes may be deducted for interest
  • The money you borrow is tax-free.


  • Possible steep closing expenses
  • Risk of becoming drowned in your mortgage if the value of your property decreases or losing your house if you cannot make the payment
  • The financing period is more extended than for personal loans

What Is a Home Equity Line of Credit (HELOC)?

A home equity line of credit (HELOC), which functions as a revolving line of credit based on the equity in your house, is comparable to a credit card. HELOC money can be taken as needed, repaid, and then retaken.

There is always a draw time of 10 years, during which you can use your credit as needed and make interest-only payments. Once the draw time is through, you must pay back all you borrowed plus interest during the payback term.

Generally speaking, a HELOC can be a better choice for you if you want to complete several home renovation projects over time. A home equity loan can be ideal if you’re considering merging high-interest credit card debt or doing a more significant home repair project that would demand all the money upfront.


When getting ready to purchase a new home or refinance your existing one, understanding how equity functions is a crucial first step.

You can consolidate debt, finance upgrades or improvements that will ultimately raise the value of your home by using the equity you generate in your home.

However, you must consider alternatives and pick the best home equity lending solution for your requirements.

By Faith B

I'm Faith, a talented copywriter with many years of experience in creating top-notch content in the housing space. While I enjoy research, singing and chatting, my friends still call me an introvert.

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