Understanding Equity

Home equity refers to the interest a homeowner has in his/her home after accounting for outstanding debts. In other words, equity refers to the portion of the property’s value that the homeowner actually owns. Understanding equity is important for homeowners for several reasons. For one, the purpose of paying down a mortgage is to build equity in one’s home. Anyone with a mortgage loan needs to understand how equity works. Secondly, homeowners can leverage their equity with a home equity loan, which turns equity into cash. We will explain more about home equity and how it can be used in what follows.

Calculating Equity

To compute the amount of equity you have in your home, take the current market value of your home and subtract all outstanding debts against your home (mortgages, home equity loans, etc.). The difference between the market value and the outstanding debt is called equity. Once you understand this formula, it’s easy to see how homeowners can increase their equity. First, they can pay down the balances of their mortgages, thereby reducing the amount of outstanding debt against the home. Secondly, the value of the home could appreciate, which would similarly boost home equity.

The Impact of the Market

In many ways, home equity is a slave to the current housing market conditions. When the market thrives, home values rise, and homeowners enjoy a concomitant rise in equity without really having to do anything. On the other hand, when the market hits a slump, home values drop, and equity follows. Plummeting home values are especially dangerous for homeowners who want to sell their homes because they will likely owe more on their homes than they are worth. Likewise, homeowners who want to tap into their equity might be unable to do so when housing values are low.

Advice on Using Home Equity

Home equity loans can offer incredibly low interest rates, but they are infinitely riskier than other types of loans. For this reason, homeowners must be judicious when using home equity. Here are some tips to guide you on how to use equity:

• Know your needs. You can access home equity two ways: with a home equity loan or a home equity line of credit. For one-time, large expenses, a home equity loan is preferable, whereas a home equity line of credit is ideal for recurring, indefinite expenses.
• Understand the risk. Remember that equity is not a risk-free source of endless cash. If you fail to make payments as agreed on a home equity loan, you could lose your home.
• Find out if you qualify for tax breaks. The interest on home equity loans is tax-deductible if you itemize your deductions, which most homeowners don’t do because they don’t have enough to justify it. Before you choose an equity loan because of the tax breaks, make sure you can actually use them first.