If you’re a homeowner, you probably hear the term “home equity” thrown around a lot.
Your realtor probably used building home equity as one reason you should buy a home. Your bank may be trying to sell you a loan against it. And your financial advisor is likely urging you to guard it as an asset for retirement or other long-term financial needs.
Home equity is a big deal—a really big deal. How big? According to the Urban Institute, Americans have over $11 trillion in net housing wealth, about $5 trillion of which comes from homes with mortgages and about $6 trillion from homes without.
If everyone in the U.S. who owned a home cashed out all the available equity in it, the total would be over $7 trillion—more than twice as much as Germany’s GDP. Yes, home equity is a really big deal.
And that’s why you have to protect it. Your home equity is a major financial asset, perhaps the largest you’ll own for a good chunk of your life. And while it represents a wealth of possibilities, it also carries a lot of risk.
Unfortunately, too many homeowners are quick to recognize the opportunities—but not so quick to acknowledge the potential financial pitfalls.
We want to make sure you’re not one of them.
In this guide, we’re going to give you the lowdown on home equity—what it really is, what you can use it for, and most importantly, how to use it responsibly.
So why not take 10 minutes and learn more about home equity and how to avoid the most common (and most serious) home equity mistakes?
What exactly is home equity?
Home equity is the difference between the market value of your home and any mortgages or loans against it.
If everything goes well, you’ll gradually gain more equity in your home as you make your mortgage payments and the value of your home appreciates.
As an example, if you have a home with an appraised market value of $400,000, and your mortgage balance is $310,000, you have $90,000 in home equity.
Ideally, you want a positive number here—and if you’ve chosen wisely and maintained your home well, most of the time, you’ll have positive home equity.
But not always.
The Urban Institute found that over the past 20 years, the average U.S. home appreciated just 1.89% per year. Some areas did much better—seeing as much as a 12.5% increase on a year-over-year basis.
But some did much worse, dropping over 18% in a single year. And if you lived through the housing bubble of 2007 through 2009, you probably know someone whose home equity was wiped out, or worse, ended up in negative equity territory, known as being “underwater.”
The point is, building home equity isn’t always guaranteed. And it’s a gradual process for most homeowners, an asset that grows slowly over time. So it’s worth protecting, since for many people, it’s the single most valuable asset they own.
Home equity isn’t a typical “investment”
A lot of people jump into homeownership because they believe it’s a good investment. And while most homes do appreciate over time, providing a financial asset in the form of home equity, it’s not an “investment” in the way stocks, bonds, and other investments are.
Your home’s primary purpose is to provide shelter for you and your family—which means you’re not totally in control of the timing of buying and selling it. You buy a house when you need a place to live and sell it when it no longer meets your needs. You may be forced to buy high or sell low due to a job transfer, for example. It’s not a “liquid” investment in the way stocks and bonds are, which can be bought and sold quickly in a way that maximizes your profit potential.
A home has huge “carrying costs.” When you own a home, you’re not just paying the cost of your mortgage, you’re paying taxes, homeowner’s insurance, and possibly even private mortgage insurance, not to mention utilities and ongoing maintenance and repair costs.
Let’s say you bought your home 5 years ago for $325,000 and today, it has a market value of $400,000— on paper, you’ve got over $75,000 in home equity. But the math tells a different story. You’ll have paid roughly $90,000 in mortgage payments, $15,000 in property taxes, another $18,000 in utilities (assuming $300 a month), and probably another $15,000 or more in maintenance and repairs. If you’ve done any significant home improvements, add another $25,000 to the total. Now you’re up to $163,000 out of pocket to gain that $75,000 in home equity. The holding costs for other types of investments are miniscule in comparison.
The problem with thinking of your home equity as a typical “investment” is that it becomes far too easy to cash it out because it looks good on paper. But that’s a short-sighted approach. Your home equity is definitely an asset you can use to meet your financial goals, but you shouldn’t treat it as you would other long- and short-term investments you’re making toward your future needs.
When should I use my home equity?
Now that you’re (hopefully) looking at your home equity with eyes wide open, let’s talk about some ways you can put it to work for you.
Using home equity to buy a new house
Let’s face it—you probably won’t live in your current house forever. You may move for a new job, because your family is growing, or even to downsize for economic or personal reasons.
You can use your home equity to help pay for your next house and lower your mortgage payments, or to “buy up” to a more expensive home than you could otherwise afford based on your income.
Using home equity for home improvement projects
If you have a major home improvement project, it may make sense to use your home equity to fund it, especially if you’re looking at a project with good return on investment. When you put your equity back into your home, it increases its market value, which adds to your home’s appreciation over time.
Plus, a well-planned improvement project increases your overall satisfaction with your home, whether it’s a finished basement, a kitchen makeover, or a new outdoor kitchen and living space.
And if you’ve got a major repair on the horizon, like a new roof, new siding, or window replacement project, you can use your home equity to bring your house back up to snuff.
A word of caution about home equity loans for home improvement, however: Not all projects are equal when it comes to recouping your costs. If you think you may be selling your home in the short term, say within three years, use caution about stripping out a lot of your equity. Some projects, like high-end siding, mid-range kitchen remodels, and energy-efficient upgrades offer a high return on your investment, meaning that you’re likely to recover your costs when it’s time to sell your home.
Other projects, like luxury master bath upgrades and room additions, don’t do quite so well, returning just 50% or so of your costs when you sell. If you sink $75,000 of your home equity into a project with a poor return, and you sell your home in a year or two, you may end up taking a loss at closing.
Using home equity to fund retirement
You can draw down the equity in your home to cover your expenses in retirement using a reverse mortgage. These loans pay you each month based on your equity and other factors and the loan is paid off when the house is sold.
Borrowing against your home equity to fund financial priorities
You can get cash for just about anything by taking out a home equity loan—home improvement projects, education expenses, or any other long-term investment in your future.
Notice we didn’t include “buying something you really want” in this list, because using your home equity for current expenses or “bucket-list” items is extremely risky, as we’ll explain in a minute.
Basically, if you’re taking out a home equity loan, it should be for something you expect to grow in value over time.
A home is unlike just about any other asset you’ll buy—it appreciates over time (sometimes slowly, sometimes quickly, but it almost always increases if you hold it long enough). However, if you buy a new car, for example, it loses value, or depreciates, the minute you drive it off the lot—and continues to drop in value the longer you own it.
If you use equity in your home to buy something that doesn’t appreciate or otherwise add value over time, you are taking a double financial hit: You’ve lost the appreciation on the amount of equity you took out of your home—and your losing even more as the item you bought depreciates.
Imagine you want to buy a $35,000 car. Your dealer offers you a 5-year loan at 6% interest, with monthly payments of $685. That blows a massive hole in your budget, so you decide to take out a $35,000, 15-year home equity loan at 5.5% to buy it (something we definitely don’t recommend!) because the payments would be a totally affordable $190 a month. Sounds great, right?
Here’s why that’s a terrible idea: If your home value increases 3% a year, you’ve lost the value of the appreciation on that $35,000 that’s no longer “yours,” which works out to thousands of dollars over the life of the loan.
You’ve also paid out over $51,000 in monthly payments plus potentially thousands more in closing costs for your loan. And that $35,000 car is now worthless or long gone. Add it up, and you’re out about $100,000. Not exactly the smartest financial decision you could make.
How do I access my home equity?
Convinced you want to tap your home equity for another financial priority? You have two options:
- A home equity loan
- A home equity line of credit (also known as a HELOC)
Before we discuss how those two products differ, let’s talk about what they have in common—which, most importantly, is that both of them are secured by your home. Although they’re called different things, in truth, they both function like a second mortgage—and your lender now has a right to your home equity.
With both types of home equity products, you’ll have a lot of upfront expenses, just as you did with your first mortgage—application fees, appraisal fees, title search fees, document fees, recording fees, underwriting fees, funding fees, and occasionally points, which are a percentage of the amount you borrow. Altogether, it could run to thousands of dollars.
These fees can make your home equity loan extremely expensive, especially if you’re only borrowing a small amount. If you’re borrowing $15,000, for example, and you pay $3,000 in closing costs, you’ve just added 20% to the cost of your loan on top of your finance charges.
Some lenders will negotiate with you and waive some of these fees—but those that do usually stick on a fat prepayment penalty, which means that if you pay your loan off before a certain period of time has elapsed, you have to pay your lender back for those fees plus a portion of the interest the lender would have collected from the loan.
In fact, even lenders that don’t waive fees may include a prepayment penalty, so be sure to read the fine print before you sign on the dotted line.
The most important thing to remember about any home equity product is that your lender now owns part of your home—and if you can’t make your payments as agreed, your lender can and will foreclose.
What is a home equity loan?
A home equity loan is a fixed amount of money that you pay back over a fixed amount of time, usually 5 to 15 years. The loans are usually fixed rate, which means you pay the same interest rate over the life of the loan.
For the most part, these are fairly straightforward loans, once you nail down the loan terms. If you’re looking for a larger amount of money for a particular need, and you know what your costs will be for that need, a home equity loan with a low fixed APR gives you predictable monthly payments.
What is a home equity line of credit?
A home equity line of credit, or HELOC, is basically a revolving line of credit—just like a credit card—that you can draw against up to your credit limit. In fact, most HELOCs come with a credit card that you can use for purchases or cash advances against your loan. You may also get checks, which you use just as you would a personal check, except the checks draw against your line of credit instead of your checking account.
Most HELOCs have adjustable interest rates, but some lenders now offer a fixed-rate hybrid option—and a few have replaced the traditional home equity loan altogether with these fixed-rate HELOCs. A fixed rate HELOC allows you to convert all or part of your variable-rate balance to a fixed rate, but you may have to meet a minimum borrowing requirement in order to qualify. This allows you to lock in your balance at a favorable interest rate and get predictable monthly payments.
HELOCs have a few other factors to consider that don’t apply to home equity loans. For example, you may only be able to draw against your limit for a certain period of time, called a “draw period.” Once that period has expired, you can’t borrow any more money against your line of credit.
For example, your lender may offer a 25-year HELOC, with a 10-year draw period and then 15 years to repay the loan. Another lender may require the loan to be paid in full at the end of the draw period, which may result in a large balloon payment.
If your loan is structured in a way results in a balloon payment, be sure to ask your lender before you close your loan what options are available for renewing or refinancing the unpaid balance if you are unable to pay it at the end of the term, so you don’t risk going into default.
You may also have ongoing fees that don’t apply to home equity loans, such as participation fees that you pay on an annual basis whether or not you use your credit line. You may also pay transaction fees each time you make a draw.
Finally, your payments depend on your balance and your interest rate, which means it’s unpredictable—your payments can swing wildly depending on how much you’ve drawn and where your interest rate lands at any point in time.
Because of all the variables involved, it’s very important that you read and understand all the terms and conditions, or you could wind up with an unmanageable loan that puts your home at risk.
HELOCs are best used for short-term financing—for example, if you’re consolidating high-interest credit card debt. They’re also useful for financing a home improvement project when you’re not entirely sure how much it will cost, perhaps because you’re doing some of the work yourself, or because the scope of the project isn’t known—like a renovation project on an older home where a problem is uncovered during the renovation process that wasn’t known at the time you started that adds considerable expense to the project.
The cash-out refinance is a third option for accessing home equity
Unlike a home equity loan or HELOC, a cash-out refinance actually replaces your existing mortgage; you end up with just one loan and one monthly payment. Your new mortgage is larger than the first; it pays off the old one and gives you the difference in cash.
Most banks limit cash-out refis to 80% of your home’s market value, although some lenders may go as high as 90% in certain situations.
The major advantage of a cash-out refinance is that you generally get lower interest rates than you can get on a home equity loan or HELOC. And if you bought your home several years ago when interest rates were higher overall, your new, lower interest rate could actually give you lower mortgage payments on the new, larger loan than your old payments on the lower, high-interest one.
Keep in mind, however, that if you do a cash-out refinance and your new mortgage exceeds 80% of your home’s value, you may have to pay private mortgage insurance, which can be as high as 1% of your mortgage per year.
Thinking of a home equity loan?
The first step before you apply is determining how much home equity you have. You can estimate it simply by subtracting your mortgage balance from your home’s estimated market value.
Or you can use Hearth’s home equity calculator, which uses publicly available data to give you an estimate—and if we can’t find public records, you can also enter your data manually. Either way, you’ll have a pretty good estimate about your current home equity.
Remember, however, that your lender will base your loan on your combined loan-to-value, or CLTV, so to see how much you can actually borrow. You can estimate your CLTV by adding your outstanding mortgage balance to the amount you want to borrow, and dividing by your home’s market value. Most lenders require a CLTV of 80% or less for home equity loans and HELOCs.
Whatever you decide when it comes to home equity loans, be sure to get quotes from several lenders so you know you’re getting the best deal. And if you’re tapping your home equity for a home improvement or repair project, it’s always a good idea to compare your other financing options, such as zero-equity personal home improvement loan or home improvement credit card, so you know which one works best for your budget and financial goals.
A glossary of home equity loan terms
We’ve given you a lot of words you may not be familiar with, but you need to understand them before you can responsibly negotiate a home equity loan. Here are a few of the most common you’ll hear during the application and approval process.
Adjustable (or variable) rate loan: This is a loan with an interest rate that changes at predetermined intervals based on movement in an index, such as the prime lending rate or the LIBOR (the London Interbank Offered Rate). Your interest rate will be the index plus your margin, which is typically 2%, so if the index is 3%, your APR would be 5%.
Amortization schedule: The amortization schedule shows you how each of your payments is applied to your loan balance, which part goes to interest, which part to principal. Over time, the percentage applied to interest will decrease as your balance goes down.
Looking at your amortization schedule is often an eye-opening experience, especially when you see the overall cost to finance your loan. That $35,000 home equity loan we talked about before? If you have a 15-year term and fixed 7% APR, you’ll pay the lender a total of about $57,000 by the end of the loan.
APR: This is the amount, expressed as a percentage, you pay the lender to borrow money.
Appraisal: A report provided by a licensed appraiser that estimates the market value of your home. The appraiser inspects your home and considers its specific details, as well as conditions around your home, to determine your home’s value. Your lender uses the appraisal to decide how much you can borrow.
Balloon payment/balloon loan: A balloon loan has a large lump-sum payment due at the end of the loan term. These are usually associated with HELOCs.
Buydown: This is a payment made to the lender to “buy down” the interest rate and lower your monthly payment. The buydown amount is based on discount points, which are equal to 1% of the total amount borrowed.
Points can save you a lot of money if you plan to stay in your home and pay off your home equity loan over a long period of time.
For example, if you borrow $50,000 at 6% for 15 years, your monthly payments would be about $425.
Now imagine your lender lets you buy down your interest rate to 5.5% for 2 points, which would cost you $1,000 ($50,000 x 0.02). Your monthly payment would now be around $410, or $15 less. It would take you 66 months to reach your break-even point and pay off your buydown amount.
Combined loan to value (CLTV): This is the ratio of the amount of all outstanding loans against your home compared to the market value of your home. For example, if your home is valued at $400,000 and you owe $300,000 in outstanding loans secured by your home, your CLTV is 75%.
Most lenders set a limit of 80% CLTV for home equity loans and home equity lines of credit.
Credit report: This is a record of all your consumer loans and payment history. It demonstrates your creditworthiness to your lender.
Your lender will use your credit score and debt-to-income ratio to decide whether or not to give you a loan and the interest rate you’ll pay. In general, you’ll need a minimum credit score of 640 and a debt-to-income ratio of 43% or below to qualify for a home equity loan. HELOCs may have tighter credit requirements.
Debt-to-income ratio (DTI): The ratio between your gross monthly income and your monthly debt payments, including your mortgage payments. For example, if you have gross monthly income of $7,500 and monthly payments of $3,000, your DTI is 43%.
Default: When you fail to make the loan payments as required in your loan, your lender considers your loan in default. At this point, your lender can pursue foreclosure.
End of draw: This is the point at which you can no longer draw on a HELOC. Depending on your loan structure, you may have to pay the balance in full, or according to a schedule agreed upon at loan origination.
Fixed rate: A type of home equity loan in which the interest rate stays the same for the life of the loan.
Fixed term: A loan that has a fixed, preset payoff date.
Index: This is a publicly available interest rate that determines what interest rate your lender charges you for your loan.
Interest rate floor/cap: This is the lowest and highest interest rate your lender can charge on an adjustable rate loan.
Lien: This is the lender’s legal claim on your property. Your original mortgage is considered the first lien and your home equity loan or HELOC is the second lien. Your lender releases the lien once the loan is paid in full.
Margin: The percentage added to your index rate that determines the amount of interest you pay on an adjustable rate mortgage.
Prepayment: This occurs when you pay off the loan before the end of the term, whether from making extra payments or selling your home. Many lenders charge a penalty if you prepay your loan.
Prime rate: The prime rate represents the interest rate that banks charge their best commercial customers to borrow money. The prevailing prime rate is generally the same for all banks.
Private mortgage insurance (PMI): A special insurance policy that pays back your lender if you default on your mortgage. This is usually required in mortgages that exceed 80% of a home’s market value.
Rate lock fee: Your lender may charge you a rate-lock fee to lock in a fixed rate on your HELOC balance.
Rescission period: Under federal law, you have the right to cancel any home equity loan without penalty within the first three business days after closing.
Title search: In a title search, your lender reviews public records to make sure you are the valid owner of your home.
Underwriting: This is the process of verifying all the information you provided on your loan application and making a decision about whether or not you qualify for the home equity loan you are requesting.