What is home equity?

Owning a home is a big accomplishment and could mean that you have access to certain financial tools. If you’ve been paying down your mortgage or your home’s value has gone up (or both), your home equity could be an opportunity standing by for you. Borrowing against your home equity is a way to turn a portion of your home’s value into money you can spend, and it’s a perk reserved for homeowners.

Equity might sound complicated, but it’s just the difference between what your home is worth and what you owe on your mortgage.

So if you feel house-rich but cash-poor and you are exploring ways to cover a large expense, learn how to make the most of your home equity. We’ll break it down right here.

How does home equity work?

When you're talking about equity in a home, you're talking, in a way, about how much of the property you have paid for. Home equity builds over time as the gap between the home’s value and the mortgage balance widens. 

The first way to build equity is by making a down payment. A down payment is the money you pay up front to buy a home. The more you put down, the less you need to borrow to complete the purchase. If you make a down payment, you start building equity from day one of being a homeowner. 

Once you own the home, equity can continue to build thanks to two things:

• Decreasing mortgage debt

• Increasing home value

In other words, as you pay your mortgage down, your equity grows. And when your home’s value goes up, your equity grows. Take a look at this example:

What is negative equity?

It’s possible to have negative equity. Negative equity means your mortgage debt is greater than your home's value. You might also hear people describe it as being "upside down" or "underwater" on their mortgage. A lot of homeowners experienced this during the 2008-09 financial crisis, when home values plummeted. It’s less common today, but it can happen.

Calculating your home equity

Curious about how much equity you have in your home? Here’s how to calculate it. 

The formula looks like this: 

current home value - remaining mortgage balance = home equity

Let’s say you owe $335,000 on your home, and it’s estimated to be worth $650,000. Follow the formula above:

$650,000 - $335,000 = $315,000 in equity 

Plug in your numbers, and you can quickly figure out how much equity you have. 

Benefits of home equity

Here are some of the benefits of having home equity.

Build wealth

You might want to figure out your home equity if you plan to sell the home down the line. Knowing what your home is worth can give you an idea of what you might walk away with if you sell. 

Lower your monthly payments

If you're paying for PMI (private mortgage insurance), having home equity could help you lower your mortgage payments. That’s because you can drop this insurance once you have enough equity.

PMI protects your lender if you stop making mortgage payments for any reason. Lenders can require PMI when your down payment is less than 20% of the purchase price. You pay an upfront PMI premium, plus monthly premiums that are added to your regular mortgage payment.

Once you reach 20% equity—based on your home's value when you bought it—you can ask the lender to drop the PMI requirement. That can lower your monthly payments. This doesn't apply to all mortgages, only conventional loans (not government-backed mortgages like FHA loans). Your mortgage servicer (the company you send your payments to) can tell you what kind of loan you have, whether you have PMI that can be canceled, and what the process is for dropping it.

Borrow

If you have equity in your home, you might be able to borrow against it. There are a few ways to do that—and some key reasons you might want to.

How can you use your home equity?

There are many ways to use a home equity loan. It’s a tool that can help you pay for expenses or fund big (and smaller) financial goals. 

Here are three of the most popular ways to use home equity. 

• Debt consolidation. If you have high-interest credit cards or other debts, you could use your home equity to pay them off. Consolidating debts with a home equity loan can leave you with fewer monthly debt payments and potentially help you save money on interest. 

• Home renovations. Ready to upgrade your kitchen? Need to put a new roof on your home? You could use a home equity loan to pay for renovations or repairs. And some renovation projects can help boost your home's value even more. 

• Major purchases. Home equity can be a great option for covering large expenses. For example, you might use your equity to pay for a wedding, cover college tuition for your child, or foot the bill for medical expenses not covered by insurance. These are just a few of the many ways a home equity loan could improve your life. 

You might also turn to your equity if you need to borrow to cover a financial emergency. It's always good to have emergency cash on hand so you don't need to borrow. But if your emergency fund is a little low, it's helpful to know that your equity is there in case you need it. 

Bottom line, how you use your home equity is up to you. And if you don't need cash, you can leave it untouched, and watch it grow as you pay down the mortgage. 

Three ways to access your home equity

We've covered some ways you can use your home equity. But how do you actually “tap into your equity” or “pull equity out”? 

The short answer is that you borrow against it. The way a home equity loan works is that it’s a second mortgage. Home equity loans are secured loans. That means you pledge something of value (collateral) as a guarantee that you’ll repay the loan. In this case, the collateral is the home. If you stop paying your loan back, you could lose your home. 

You have a few options: 

• Home equity loan. A home equity loan lets you borrow against your equity and get a lump sum that you can use for just about anything. Home equity loans usually have fixed interest rates, and are paid back over a period that may range from 5 to 30 years. 

• Home equity line of credit (HELOC). A HELOC also lets you borrow against your equity, but you get a revolving credit line instead of a lump sum. For the first few years, you can borrow, repay, and borrow more as often as you like, up to your credit limit. This is called the draw period. When the draw period ends, the repayment period begins, and it typically lasts 10 to 30 years. Most HELOCs have a variable interest rate. Achieve offers a fixed-rate HELOC.

• Cash-out refinance. Refinancing a mortgage means getting a new home loan to pay off your old one. With a cash-out refi, you get a new, larger mortgage. The new loan pays off the old mortgage, and you get the difference in cash at closing. 

How do you decide which is better? You can start by comparing costs. If your original mortgage has a very low interest rate compared to what you could get now, you might not want to do a cash-out refinance mortgage. It doesn’t make sense to pay off a mortgage with a more expensive mortgage. A home equity loan or HELOC would be a better option. You can also consider how much flexibility you need. Since a home equity loan is a one-time lump sum, a HELOC may be more convenient. 

Talk to a mortgage advisor to get a better idea of how to make the most of your equity.