In simple terms, home equity is the amount that your home is worth less any mortgage loan balances you owe to your lender. If you purchase a home valued at $400,000 with a $300,000 mortgage, you have $100,000 of equity in your home. As long as your home's value remains stable, your equity will most likely grow over time.
Mortgage vs. Equity
Lenders secure mortgage loans by placing a lien on the real estate until you pay off the mortgage balance. A lien is a legal instrument that gives the lender the right to claim your property if you default on the loan payments. Unless you have taken out a less common type of loan like an interest-only mortgage, each mortgage payment that you make reduces the amount of the your loan and builds the amount of equity that you have in your home.
Your Home's Value
Although many people think their home is worth what they paid for it, that is not always the case. Your home’s value is only worth what a buyer would pay for it, known as fair market value, and that number can fluctuate up or down over time. Keeping up with routine maintenance and making improvements on your home can help maintain the value of your home, giving you more equity, but sometimes that is not enough. If the demand for homes in your area declines, the price of houses usually declines with it. Despite the fact that you paid $400,000 for a home and took out a $300,000 mortgage, if your home is only worth $300,000 in a few years, you would essentially have no equity in it.
Home Equity Line of Credit
If you have a substantial amount of home equity and a good credit rating, your bank may approve you for a home equity line of credit. HELOC loans work similar to credit cards, as the lender gives you a specific line of credit that you can use if and when you need it. The amount of equity in your home acts as collateral for this type of loan. If you have a $50,000 HELOC, you have the option of withdrawing $10,000 to do repairs and leaving the remaining $40,000 of the credit line untouched. Once you use any money from this line of credit, you must repay it like you would a credit card. For HELOC loans in which your lender applies your payments to both principal and interest, each payment you make reduces your balance and increases your equity.
Home Equity Loans
Many lenders offer loans on the equity you have in your home. These home equity loans act like a second mortgage where the lender gives you a lump sum of money less than or equal to the amount of equity in your home and a payment plan to repay the loan. If you have a home worth $400,000 with a $300,000 first mortgage and a home equity loan, or second mortgage, for $50,000, you are left with $50,000 worth of equity in your home. The remaining value of the home is, in essence, owned by the lenders until you repay the balances.
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