5 Things You Need to Know About ‘Home Equity’ Before Getting a Mortgage
They say that buying a home is the biggest investment you’ll ever make. And, while the jury is out on whether it’s always the best long-term investment for everyone, it’s important to learn the lingo so that you’re handling this big decision—and the big money that goes along with it—wisely.
One of the most crucial things to know about home finance is equity. To break down exactly what equity is and why it’s important, we spoke to two real estate experts. Here are five things they say to know:
1. What is equity?
Home equity is the difference between the appraised value of your home and your current mortgage balance, according to Bank of America. Essentially, it’s the portion of the home that you actually own, financially, based on the amount you’ve paid into it so far (not including the sum paid for interest).
So, if your home is worth $300,000 and your current mortgage balance is $200,000, then you have paid $100,000 on your mortgage, meaning you have $100,000 in equity in your home.
2. Are there other ways to measure this?
Yes, sometimes people use a loan-to-value (LTV) ratio to express the amount of equity in a home, according to Bank of America. Here’s the basic loan-to-value ratio formula: current loan balance ÷ current appraised value = LTV. So, in the aforementioned scenario, the equation would be: $200,000 ÷ $300,000 = 0.67. That’s a loan-to-value ratio of 67 percent.
3. How do you build equity?
There are two ways to build equity in a home, according to mortgage specialist Richard Barenblatt of GuardHill Financial Corp. in New York City: “The property appreciates over time and will be worth more than what you paid. Alternatively, when you pay down your mortgage, you owe less to the bank.” The former is the most common way of doing so.
If you want to build equity even faster, you can “prepay” your mortgage, which means making extra payments on your principal loan balance, according to Bankrate. Additionally, this saves you money over time in interest. However, some mortgage lenders penalize for early payments, so make sure you check your fine print.
4. Why is equity important?
First off, most residential lenders require that you pay 20 percent into the equity of your new home upon purchasing it in the form of a down payment. “Borrowers who have less than 20 percent equity in their properties are generally required to obtain PMI (private mortgage insurance), which protects the lender from a borrower’s nonpayment in these higher-risk situations,” says Mark A. Hakim, an attorney at SSRGA law firm. Meaning, if you can’t pay a hefty chunk on your home right off the bat, you’re considered a risky prospect, so the lender wants extra protection to make sure they don’t get stiffed if you can’t pay.
Hakim adds that the cost of the PMI “is in addition to and does not count towards payment of the interest or principal on a loan (thus, does not build any equity) and generally can be requested to be removed when the borrower obtains more than 20 percent equity in their property.”
5. What are other uses of home equity?
When you’ve paid off a good amount of your mortgage and built up decent equity in your home, you can take that money out again—whether to finance a renovation or invest in a business venture—either via a home equity loan (also known as a second mortgage), home equity line of credit (HELOC), or a cash-out refinance, according to NerdWallet.
For the former, if you still have a mortgage, you’ll basically be paying a second payment for the home equity loan, according to NerdWallet. Meanwhile, if you decide on a cash-out refinance, your current loan will be placed with a new term, interest rate, and monthly payment.
Want a run-down of other real estate buzzwords? Here, 10 real estate terms experts say every millennial should know.