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What is Home Equity and How Does it Work?

October 12, 2022
Poppy Plan 3 Exterior at Sunset in Ontario Ranch, CA

One of the main reasons people choose to buy a home rather than rent is the ability to accumulate home equity. When you rent, your payments go to a landlord and you don’t gain any long-term financial value.

When you own a home, every payment you make is a financial investment not only in your home, but your future.

Let’s explore the benefits of home equity and how to use it for loans or other financial needs.

Home Equity Explained

Home equity is the difference between what you owe on your mortgage and what your home is currently worth. Of course, the value of your home varies over time based on the housing market. As you make payments towards your home mortgage, the amount you pay can increase your financial stake in your property.

For example, once you’ve calculated how much home you can afford, you:

  • Purchase a home for $400,000
  • Contribute a 20% down payment of $80,000
  • Take out a mortgage to cover the remainder of the purchase price
  • Renovate your kitchen, increasing your home’s value
  • See an increase in home values in your neighborhood
  • Realize increases in your home’s value, making it worth $500,000 in the current market

In this scenario, you owe $250,000 on the home. You would have $250,000 in home equity ($500,000 home value - $250,000 loan balance = $250,000 equity).

That’s why many people choose to purchase a home instead of renting, since it can serve as an investment, in addition to providing shelter and comfort. Over time, your equity can increase, simply due to market conditions.

Making extra payments on your mortgage, or paying more on each payment than is required, can also help you build additional equity.

What Can You Do with Home Equity?

Depending on your expenses and your long-term financial goals, you can use your home equity in different ways. Some examples of how to use the equity in your home are:

1. Using Home Equity to Pay Off Debt

Different kinds of debt have different kinds of terms and interest rates. For example, credit card debt typically has higher interest rates compared to loans like a home loan or home equity loan. You can take out a home equity loan to pay off your high-interest debt at a lower rate, if you qualify for this type of loan.

A home equity loan is a lump-sum loan you take out based on the amount of equity you have in your home. Home equity loans have fixed rates, so you know exactly what you’ll pay over time.

There are also potential tax benefits for home equity loans. The Tax Cuts and Jobs Act makes home equity loan interest tax-deductible as long as the loan proceeds are used to substantially improve, build, or buy the taxpayer’s home.

Home Equity Lines of Credit

There are also home equity lines of credit (HELOCs) available. These provide borrowers with a revolving line of credit, similar to a credit card. You can borrow from it during the draw period before having to repay it back during the repayment period. HELOCs typically have a variable interest rate.

Going back to the above scenario – say you have $250,000 of equity and have $10,000 of high-interest debt. You could take out a HELOC loan, pay off that debt, and then pay off the home equity loan at a lower interest rate to save money on overall interest.

2. Using Home Equity Loans for Renovations

Some homeowners consider building home equity by making home improvements. According to Bankrate, home improvements generally provide around a 70% return on investment. Added bonus? Your home becomes more enjoyable and suited to your style while you live there.

You can also use home equity loans to finance home improvements and renovations. Over time, these improvements can help increase your home’s value, which can help you recoup what you spent on the upgrades and increase your equity overall.

3. Investing in the Future

A HELOC or home equity loan can also help you cover costs for an expense that could help you earn more money over time, through career growth or another investment. For example, you might take out a home equity loan or HELOC for:

  • Educational expenses
  • Business startup or expansion costs
  • Another investment

If you’ve built equity in your home, you may be able to use some of it for other expenses, including making home improvements. You can also use home equity to buy a nicer home. For example, if you’ve been building equity in one home, you can use that equity towards buying a bigger home or possibly toward purchasing a second home.

4. Getting “Paid” in Retirement

Once you turn 62 years old, you may be eligible for a Home Equity Conversion Mortgage (HECM) through the U.S. Federal Housing Administration. Also known as a reverse mortgage, a HECM pays you money based on the equity in your home. There are lump-sum, line of credit, and monthly payment options available.

If you sell your home, or if you move out of the home for more than six months of the year, you will have to repay the reverse mortgage loan balance. If the homeowner passes away, an heir will be responsible for paying back the HECM.

Tips for How to Use Home Equity

To recap, the following are options for how to build equity in a home:

  1. Pay off your mortgage
  2. Add value to your home through renovations, upgrades, and additions
  3. Live in a home where market conditions are driving up the value of the home

Once you’ve mastered how to build home equity, be mindful of using it. A home equity loan, HELOC or HECM still needs to be paid off. It’s another form of debt in your home financing plan for which you’ll be responsible. It’s wise to use home equity for an investment that will increase your financial standing, so you don’t increase the amount you owe.

If you’re purchasing a new home, including a new construction home, you can automatically increase your home equity by paying a higher percentage toward your home’s down payment when you get a mortgage.

It’s nice to know that as you live in your home and responsibly make payments to pay it off, you may also be building equity, as long as the home value stays steady or increases. Home equity can help provide financial peace of mind while you’re living in the home, giving you an investment option to draw from when you need it.

Want to Build Equity with a New Home?

At Brookfield Residential we build the best places to call home throughout North America. We’re ready to help you customize your dream home to include all the fixtures and amenities you want, including smart technology and stylish finishes. Our team is here to support you throughout the entire homebuying process, from getting a loan preapproval, applying for a mortgage, and more.

For more information about Brookfield Residential’s homes, contact our team today!