Mortgage Q&A: “What is home equity?”
You’ve probably heard the phrase “home equity” thrown around, likely during a commercial urging you to pull the equity out of your home using a home equity line of credit (HELOC).
So what the heck is it? In short, home equity is the market value of your property less any liens/mortgage balances.
Let’s look at a quick example:
Current property value: $500,000
Existing liens: $350,000 first mortgage, $100,000 second mortgage
Home equity: $50,000
In the scenario above, you’d have total liens of $450,000 on a property currently worth $500,000.
The $50,000 difference would be your “home equity,” or actual ownership in the home.
And you could tap into this home equity by refinancing or taking out a home equity loan/HELOC, though it’s not always recommended because doing so increases your total loan balance and monthly mortgage payment.
Home Equity Builds as Mortgage Payments Are Made
As you make mortgage payments each month, your home equity will steadily increase.
In the beginning, most of your mortgage payment will go toward interest, thanks to the sizable outstanding balance.
But as your mortgage balance decreases over time, more of your monthly payment will go toward principal, which really builds your home equity (learn more about mortgage amortization).
Note that interest-only home loans don’t technically build home equity, as you’re only paying off accrued interest each month, but if home prices appreciate while making interest-only payments, you will still gain equity in your home.
This principle explains why so many elected to go with interest-only loans, or even option arm loans during the mortgage boom. The general thinking was that you’d gain home equity no matter what.
And we all know how that ended…
Home Equity Increases as Home Prices Rise
However, if home prices do rise, you will grab a larger amount of home equity.
Using our previous example, if the value of the home increased to $550,000, your home equity would rise to $100,000.
It would actually be more than $100,000 thanks to mortgage payments made between the time the home’s value increased from $500,000 to $550,000, but you get the idea.
This is where homeownership starts looking attractive. That combination of regular payments reducing the principal balance and home prices increasing can be pretty sweet.
When the mortgage balance(s) exceeds the current value of the home, the loan(s) is considered underwater.
This would put you in a position of negative equity, making it difficult to refinance, as your loan-to-value would surpass 100%.
However, there are a few refinancing options for those with negative equity.
Negative equity became a major problem during the latest mortgage crisis. Put simply, many homeowners elected to take out zero down mortgages and/or negative amortization loans just as home prices peaked.
This deadly combination of falling home prices and low and no-down payment loans sapped borrowers’ equity, leaving many with no choice but to walk away from their overpriced mortgages. This partially explains the record number of foreclosures seen nationwide.
Read more: 10 ways to build home equity.