Home equity is the value of your house minus the amount you owe on your mortgage or home loan. When you first buy a house, your home equity is the same as your down payment. If you buy a house for $250,000 with a down payment of $25,000, you begin with $25,000 in home equity. After you buy a house, the value of your home equity can change and hopefully it will increase.
How your home equity can increase and how it is calculated
One way you can increase your home equity is by making your monthly mortgage payments. Part of this payment goes towards paying down the principal, which is the amount of money you owe for your home.
In the early years of homeownership, more of your monthly bill goes to paying for the interest than paying down the principal. That means your mortgage payments are likely to make only modest contributions to your home equity. You may be able to build equity faster by paying more than you owe each month, by making an extra payment each year, or by moving to bi-weekly mortgage payments. Making additional payments also helps save on interest because you are paying off your loan faster.
The other way your home equity can increase is when the value of homes in your community increases. As housing prices around you go up, your home's value will probably go up too.
For example, if you bought your house five years ago for $250,000 and the current fair market value of your house is $300,000 – that extra $50,000 becomes part of your home equity. This is great because rising home prices can help you build equity.
Remember that when home prices in your community fall, the amount of your home equity can go down as well. If the fair market value of your home declines from $300,000 to $280,000 then your equity will decline by $20,000.
To estimate your home's equity, look up the current market value of your house on a website like Zillow and Redfin. Remember these sites just provide an estimate. Getting your home appraised will give you a more accurate estimate but you will have to pay an appraisal fee.
Take the current market value of your house and subtract from it your current mortgage balance, which you will find on your monthly statement. The number you get is the value of the equity you have in your home.
Why your home equity matters
One reason to check your home equity is if you are paying Private Mortgage Insurance (PMI). Many mortgages require you to pay for PMI until the equity you have in your home reaches 20%. Once you reach this figure, it is possible to stop paying PMI for many types of loans and save money. If house prices are rising in your community, you may have more home equity than you realize. It's worth checking.
It's important to know your home equity if you are thinking of refinancing your loan. When mortgage rates are falling, it may be possible to refinance your mortgage and save money on interest, reduce your monthly payments, or pay off your loan sooner. Your home equity influences the terms of a loan you might get.
You can also borrow against the value of your home equity to get cash to finance home improvements, pay for college, or pay off other higher interest debts. This is called a cash out refinance. You refinance your loan for more than you owe and take the difference in cash.