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?
One way you can increase your home equity is by making 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 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.
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.
How can you calculate your home equity?
To calculate your home's equity, look up the current market value of your house on a website like Zillow or 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, plus 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?
One reason to check your home equity is if you are paying Private Mortgage Insurance (PMI). Many conventional 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 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.
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 and save money on interest, reduce your monthly payments, or pay down your loan sooner. By refinancing, the total amount of finance charges may be higher over the life of the loan. Your home equity influences the terms of a loan you might get.
You can also borrow against the value of your home's equity to get cash to finance home improvements, pay for college, or consolidate debts. This is called a cash out refinance. You refinance your loan for more than you owe and take the difference in cash. How much home equity you have affects the amount of money you might be able to borrow.
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. Take a 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)
In this example, you can see to calculate your tappable equity, you need to take your maximum new principal mortgage balance ($300,000) and subtract from it 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 the 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.