What is home equity?
Learn why the equity in your home matters
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 can your home equity increase?
You can increase your home equity by simply making mortgage payments. Part of your 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 toward paying for interest instead of 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 mortgage 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.
Home equity also increases when the value of your home increases. As housing prices in your community increase, 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, the increase in value of $50,000 becomes part of your home equity.
Likewise, when home prices in your community fall, the amount of your home equity can decrease as well. If the fair market value of your home declines from $300,000 to $280,000, your equity will decline by $20,000.
How can you calculate your home equity?
To calculate your home's equity, start by finding the current market value of your house on a website like Zillow or Redfin. These sites provide an estimate—a home appraisal will provide 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. Also subtract any other loans you might have that use your home as collateral. The number you get is the estimated value of the equity you have in your home. Look at this sample calculation:
|Current fair market value of home||$275,000|
|Current mortgage balance||- $150,000|
|Current balance on second home loan||- $25,000|
|Estimated home equity||$100,000|
Why does your home equity matter?
Your home equity matters because it represents a financial asset—a sum of money you own that can benefit you in several ways. For instance, if you are paying private mortgage insurance (PMI), it’s important to keep an eye on your current home equity. Many conventional mortgages require you to pay for PMI until your home’s equity reaches 20%. Once you reach this figure, it is often possible to remove PMI from your mortgage and save money. If house prices are rising in your community, you may have more home equity than you realize.
Your growing home equity can also be an available cash source for big expenses. You can borrow against the value of your equity to finance home improvements, pay for college, or consolidate debts. This is called a cash out refinance. A cash out refinance replaces your current mortgage with a new, larger loan and gives you a portion of your home equity in cash at closing. How much home equity you have affects the amount of money you might be able to access and borrow.
Finally, your home’s equity can help you refinance your mortgage. That’s because the value of your equity affects your loan-to-value ratio (LTV). Having a significant amount of home equity lowers your LTV. Lenders often prefer customers with lower loan-to-value ratios and may offer them lower rates or better terms on refinancing as a result.
What is "tappable equity"?
"Tappable equity" is a phrase real estate professionals use to describe the amount of money you might be able to access from your home’s equity. Most of the time you can’t borrow your equity’s full value. Instead, you can only "tap" a portion of its value because most lenders require you to keep 20% equity in your home. Look at this sample calculation.
|Current fair market value of home||$375,000|
|Current mortgage balance||- $225,000|
|Estimated home equity||$150,000
(40% of the total value)
|Maximum new mortgage balance||- $300,000
(keeps 20% equity in home)
|Estimated tappable equity||$75,000
($300,000 - $225,000)
This example shows how to calculate your tappable equity: take your maximum new principal mortgage balance ($300,000) and subtract it from the amount you owe on your mortgage ($225,000). This gives you a total of $75,000 in cash you may be able to tap from your home’s equity.
What is a gift of equity?
When a friend or family member sells you a home (or real estate) for a price below the fair market value, it is called a gift of equity. Since the equity is the difference between the sales price and the home’s market value, this “gift” does not include money. If the buyer supplements the transaction with a conventional mortgage, sometimes a gift of equity can help the buyer avoid paying private mortgage insurance if the equity surpasses 20%.
Some lenders allow a gift of equity to be used as a down payment on a home. Home sales involving a gift of equity typically require an appraisal and a letter or documentation that outlines the appraisal price, the home’s sale price, a statement from the buyer and seller that clearly states their relationship and nature of the gift, and signatures from all parties.
Keep in mind home sales involving a gift of equity will still require closing costs. A gift of equity may also require payment of gift taxes. Consult your tax professional about the taxes you may need to pay.
Last reviewed and updated October 2023 by Freedom Mortgage Corporation.