Home Equity: What is It and How Does It Work?

Home equity

Home equity is defined as the value of a homeowner’s interest in their property. It is the estimated value of your home minus any outstanding mortgages and loan balances (in practical terms). In most cases, your property stake will build over time when you repay the mortgage balance or add more interest to your home. Homeowners can use their real estate equity as collateral. It is valuable to secure a home loan, a traditional home equity line of credit (HELOC), and a fixed-rate HELOC.

How Home Equity Works

Suppose a portion or all—of a home is purchased through a mortgage—the financing companies own shares in the property until the loan obligation has been completed. Home equity is the part of a house’s current value that the buyer possesses at a specific point in time. 

Equity in property is acquired from the down payment you paid during the initial purchase of the property. Thereafter, you get more equity through your monthly mortgage settlements. It means the contract part of the repayment is used to reduce the outstanding loan amount. You can also benefit from a higher property appraisal amount as it increases your home equity value. 

Special Considerations

Home equity mortgages

Unlike other investments, equity cannot be quickly converted into cash. The net worth calculation is based on an estimate of the current market value of your property. However, this valuation does not guarantee that the property will be sold at that price. 

Most homeowners can leverage their home equity as collateral. It is helpful to obtain a real estate loan or line of credit (HELOC) or fixed-rate HELOC, a type of home equity mortgage, and a hybrid HELOC.

A home equity loan, sometimes called a secondary mortgage, usually allows you to borrow a one-time loan at a fixed interest rate against your current property value. These mortgages are utilized to finance large expenses, such as college tuition or house repairs.

The Home Equity Line of Credit (HELOC) is a revolving line of credit, typically with an adjustable interest rate, allowing you to borrow a certain amount of money within a specified period. HELOCs operate in a manner comparable to credit cards, where you can borrow continuously up to the approved limit while paying the balance.

Home equity example 

Consider a buyer purchases a house for $100,000 with a 20 percent down payment (including the remaining $80,000 mortgage), then the homeowner’s equity will be $20,000. However, if the home’s market value remains the same for the next two years and the $5,000 mortgage is paid to the financier, the homeowner would have a worth of $25,000 at the end of the two years.

Consider the home appraisal value has increased by $100,000 in the past two years. The financier applies for the same $5,000 mortgage, then the homeowner will have home equity of $125,000.

Related Terms

Second Mortgage

A second mortgage is a home mortgage made while the initial home loan is still in effect. Learn about the requirements for a second mortgage and how to apply.

How to Calculate a High-Ratio Mortgage and What it signifies to Investors

A high-interest mortgage refers to a loan where the loan value is close to the property appraisal value being used as collateral. More so, the loan value approaches 100% value of the property.

What Is Negative Equity?

Negative home equity occurs when the real estate property value is lower than the outstanding balance of the mortgage loan used to purchase the house.

Mortgage Home Equity Withdrawal (MEW)

MEW refers to removing the owner’s stake from the property through a mortgage loan against the property’s current market value.

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