What is equity in a home?

• Home equity is the portion of your home that you own outright.
• You can tap home equity to pay for renovations, consolidate debt, and more
• Home equity loans and home equity lines of credit are two ways to access home equity.

Imagine your home is a pizza. Every time you make a mortgage payment, you eat a small slice of that pizza, and that share of your home becomes yours. The leftover slices are what you still owe your lender. As your home’s value increases, the pizza grows and you eat the extra slices. 

Home equity represents the share of the pizza you have eaten. It’s the difference between the current value of your home and your remaining mortgage balance. In other words, it’s the portion of your home that you own outright.

Home equity is the share of your home that you own. It increases as you make mortgage payments, and it also increases as your home appreciates in value. 

When you first buy a house, your home equity is equivalent to your down payment. For example, if you buy a $200,000 house with a 20% down payment, you have $40,000 in equity. 

Let’s say that after two years, you’ve paid down about $4,000 of the principal on your mortgage. (Interest payments don’t count toward home equity.) At the same time, your home has appreciated in value $10,000. You now have $54,000 in home equity. 

The easiest way to calculate home equity is to subtract the remaining balance on all loans secured by your home from the current value of your home. So if your home appraises for $200,000 and you have an outstanding mortgage balance of $150,000, you have $50,000 in home equity. 

One of the perks of building home equity is that you can eventually borrow against it. Lenders typically require that you have at least a 15% to 20% stake to take out a home equity loan or home equity line of credit (HELOC). 

The amount of home equity you have will impact your borrowing limit. Most lenders allow you to borrow up to 80%-85% of your equity.

You can use the money for a variety of purposes. For example, many homeowners choose to use their home equity to renovate their home. Upgrades may increase the value of your home, which means you’ll have even more equity once you’ve paid off your home equity loan or HELOC. If you use the loan to substantially improve your home, you can deduct the interest on your tax return. 

Debt consolidation: If you have a lot of credit card debt, you may be able to save money by tapping your home equity to pay it off. That’s because home equity loan rates and HELOC rates are much lower than credit card interest rates, which currently average 20.68%.

Once you use the loan to pay off your credit cards, you’ll just have one monthly payment to worry about. 

Starting or growing a business: Starting or growing a business can be a risky investment, but if you’re confident that your business plan will generate high enough returns, you can tap your home equity to get started.

Home equity loans and HELOCs come with lower interest rates than business loans — just remember that you could lose your home if you fail to repay. 

Buying an investment property: As with all investments, buying a rental property comes with risks. But if you’ve run the numbers and can cover your costs with the rental income, you can use your home equity to help you make a larger down payment. 

Paying for education: Whether you’re funding your child’s college costs or paying for continuing education for yourself, you might need financial help with tuition.

Home equity loans and HELOCs tend to have lower fixed rates than Parent PLUS loans, but you’ll be giving up forgiveness options and putting your house on the line. Consider your options carefully before using your home equity to pay for education. 

There are generally four ways to get cash from your home, and each comes with benefits and drawbacks. 

A home equity loan is a type of second mortgage that allows you to borrow a lump sum of money against your home equity, which you’ll typically repay in fixed monthly payments over five to 30 years. You can usually borrow up to 80%-85% of your home’s value, less what you owe on your mortgage, but some lenders may offer more.

You’ll need to meet the lender’s equity, credit score, and debt-to-income requirements to qualify. Often, lenders require you to have at least 15% equity in your home, a credit score in the mid-600s, and a debt-to-income ratio of less than 43%. 

To get a home equity loan, you’ll need to schedule an appraisal to determine your home’s market value. Home equity loans also come with other closing costs ranging from 2% to 5% of the loan amount. Because of the work involved, most lenders won’t offer a home equity loan for less than $10,000. If you just need a small amount, consider a personal loan instead. 

A home equity line of credit (HELOC) is another type of second mortgage, but it opens a revolving line of credit, much like a credit card. This gives you more flexibility than a home equity loan. 

You can withdraw what you need (up to the limit determined by your home equity) at any time during the draw period. The draw period typically lasts between five and 25 years.

One benefit of a HELOC is that you’ll typically only make interest payments during the draw period. Once the repayment period begins, you’ll make full payments of principal and interest, and will no longer have access to the line of credit. 

HELOCs typically come with variable interest rates. That means your payments will fluctuate as the prime rate changes, based on the Fed’s benchmark rate. That said, some lenders do offer fixed-rate HELOCs, which provide predictable payments. 

Unlike a second mortgage, a cash-out refinance replaces your mortgage with a larger one, leaving you with one monthly payment. You’ll then receive cash equivalent to the difference between your original mortgage and the new one.

For example, if you owe $160,000 on your mortgage and your balance after a cash-out refinance is $200,000, the lender will issue you $40,000 in cash, minus closing costs. The amount of cash you can withdraw is usually limited to 80% of your home equity. 

A cash-out refinance is typically beneficial only when you can get a new interest rate that is less than or equal to your current mortgage rate. If the interest rate is lower, you might even be able to keep your mortgage payments the same while accessing a lump sum of cash. 

If you’re over 62 and have paid off your principal residence or have a low mortgage balance, you can get cash from your home equity through a reverse mortgage. 

You can opt to receive the money as a lump sum with a fixed interest rate, or you can receive monthly payments or draw against a line of credit with a variable interest rate. You won’t have monthly payments with a reverse mortgage. Instead, the full balance becomes due when you move out, sell the home, or pass away. 

Reverse mortgages aren’t cheap — you’ll have to pay closing costs, mortgage insurance premiums, interest, and other fees. Bear in mind that it’s possible the loan balance could grow beyond the value of your home, leaving your heirs to decide between paying off the remainder of the loan or surrendering the home to the lender. 

• Low interest rates: You’ll likely pay less to tap your home equity than you would pay to take out a personal loan or carry a balance on your credit card. 
• High borrowing limits: You can typically borrow up to 80%-85% of your home equity. That may mean access to more cash, depending on how much equity you’ve built. 
• Long repayment terms: Repayment terms on home equity products can last up to 30 years. With a personal loan, you typically have to repay the balance within five years. 
• Flexible use of funds: You can use the money you borrow from your home equity as you see fit. And with a HELOC, you can borrow repeatedly without reapplying. 
• Possible tax deduction: If you use the funds for a renovation or addition, you may be able to deduct the interest paid on your tax return. 

• Two mortgage payments: If you tap your home equity, you have to pay it back. Reconsider borrowing against your home equity if two loan payments a month would leave you overextended. 
• High closing costs: Home equity products come with closing costs, such as appraisal fees, origination fees, attorney fees, and title fees. These costs range from 2% to 5% of the loan amount.
• Slow to fund: Getting cash from your house can take between two weeks and two months. A personal loan is much quicker — you can get the funds as soon as the next business day, which makes more sense in an emergency. 
• High minimums: Most lenders won’t issue a loan for less than $10,000, and some have higher limits. It’s not a good idea to borrow more than you need, so if you only need a small amount, consider a personal loan instead. 
• Risk of foreclosure: The most serious drawback of home equity products is that they are secured by your home. If you fail to make payments on time, the lender could take your home in foreclosure. 

One of the benefits of building home equity is that you can access cash from your home through a loan or line of credit. However, that doesn’t mean you should. There are good reasons to borrow against your home equity, like paying for a home renovation. However, if your financial circumstances change and you can’t afford to repay the loan, you could lose your home. It’s important to consider the pros and cons before tapping the equity in your house. 

Editorial Disclosure: All articles are prepared by editorial staff and contributors. Opinions expressed therein are solely those of the editorial team and have not been reviewed or approved by any advertiser. The information, including rates and fees, presented in this article is accurate as of the date of the publish. Check the lender’s website for the most current information.

This article was originally published on SFGate.com and reviewed by Lauren Williamson, who serves as the Home and Financial Services Editor for the Hearst E-Commerce team. Email her at [email protected].