Confusion around home equity is one of those conversations that comes up frequently. I briefly talked about it over in the FAQ section, but thought it deserved a full post.

We've all heard people talk about home equity as if there were hidden pots of gold in the attics of houses. It all sounds very exciting, but for those new to the industry, the idea can be confusing.

As new home buyer tries to educate themselves on investing in their first home, they may ask their Realtor to explain home equity. The agent may give a very brief response and advise their client to speak with a financial adviser or mortgage lender.

Remember, real estate agents are not allowed to give advice outside of their actual expertise! We can get in some hot water for doing so! We MUST advise that you speak with an expert when questions regarding finances, law, or home construction come up.

So off the buyers go to the financial guy and they get a detailed and technical explanation. Half the words that leave his mouth might as well be another language. Instead of asking for a simplified explanation, many just shrug it off and give up.

As a Realtor, I am going to tell you to be sure to talk to your financial adviser on all financial confusions you may have, but hopefully I can help shine some light on the concept!

What is home equity?

First let's briefly think about mortgage. Let's say Joe is buying a house. The house he has his eye on is listed for $200,000. Joe does not have $200,000 sitting in his bank account to buy the house, but that's OK because his bank approved him for a mortgage loan! The bank agrees that if Joe can put down $40,000 (20% of the purchase) from his own savings, they will allow him to borrow the remaining $160,000 to purchase his new home.

Over the next 30 years Joe will slowly pay the bank back. Joe's monthly payment includes Principal, Interest, Taxes, and Insurance. Principal is the portion that goes to paying back the $160,000 loan. The bank will collect interest as a fee for allowing Joe to borrow the money. His home insurance and local taxes will also be taken care of through that mortgage payment. 

It is important to understand that although the bank provided the funds to purchase the property, the bank does not OWN Joe's house. They do, however, have an interest in it. The bank will use Joe's property as collateral if the situation arises where Joe can no longer make his payments.

How much of the house does Joe own free and clear from the bank?

On settlement day, Joe owns the $40,000 of his property that he put down. Each month he will whittle away at that $160,000 loan and increase the amount of the property that he owns free and clear from the bank.

Market value of the home ($200,000) - amount owed to the lender ($160,000) = home equity ($40,000)

Increased market value brings increased equity

Joe's property is valued at $200,000. The house next door, which is the same size and style, sold for $250,000. The difference is that the neighboring house has an updated kitchen and bathroom. If Joe makes similar updates to his home, his property value will increase.

If Joe's property market value is now $250,000 and he owes the bank $160,000, then his home equity has increased to $90,000!

From an investment perspective, buying a house where you know you can add value is always worth considering!

It's a tricky balance, but this concept is the reason why some are willing to buy a fixer upper at a low price knowing that after they provide the required TLC, the market value and home equity will increase. We will talk about the risks and rewards in buying a fixer upper another day!

HOMECOASTER BUYER ADVICE:

Make sure you ask your agent for a comparative market analysis BEFORE you make an offer on a house. Know what similar properties are selling for in the area and make sure the seller has priced their home fairly. If you overpay for a property, it will hurt your ability to increase it's value. 

Can I use all that equity I have saved up?

Now that you have a good idea of what the home equity actually is and how you can build it up, the bigger question arises,"Am I able to actually use all that equity that I have saved up?"

Yep! There are a few ways that you can put that pot of gold to work for yourself.

Before you make any decisions, it is highly recommended to consult your financial adviser to determine IF tapping into your equity is wise.

1. Home Equity Loan

A home equity loan is a second mortgage. When you apply for a home equity loan, the bank will first have your property appraised to determine its market value. Once they determine how much equity you own, they will let you know the maximum amount they are willing to lend you.

The bank will give you cash and hold on to your pot of gold until you pay it back. Just like with your mortgage, you will pay them back monthly with interest.

The benefit is that you get a lump sum of cash that you can use for virtually anything. The down side is that you are now taking on an additional monthly payment and you are offering up more of your house as collateral to the bank.

2. Home Equity Line Of Credit (often referred to as HELOC)

This is similar to a credit card. The bank will approve you for a certain dollar amount based on your equity. You can use what you need, when you need it, over the agreed to term/draw period (often 10 years). Many lenders allow you to pay interest only during the draw period. At the end of that  'draw period', you will begin to pay back the principal + interest.

The benefit to the HELOC over a credit card is that you typically will have a much lower interest rate with your HELOC than you would with a credit card.

3. Fund your next home purchase

Let's go back to talking about our friend, Joe. Let's assume he didn't touch his equity and is ready to sell his house and move into a bigger home. Over the years he has paid his loan down so that he now owes the bank $100,000. His property sells for $250,000. First, he will have to pay off the remainder of his loan ($100,000) to the bank. That leaves him with $150,000! He will need to use that profit to pay any settlement and title transfer fees, but then he can roll the remainder into a down payment on his next home!

When you purchase your first home, the biggest challenge tends to be saving for that down payment. Once you make that first purchase, building your home equity is the easiest way to save the funds for that next home!