Home Equity: What It Is, How It Works, and How You Can Use It

What Is Home Equity?

Home equity is the value of a homeowner’s financial interest in their home. In other words, it is the actual property’s current market value less any liens that are attached to that property. 

The amount of equity in a house fluctuates over time as more payments are made on the mortgage and market forces impact the property's current value.

Home equity can represent more than a mortgage loan being paid off. It is an asset that homeowners can borrow against to meet important financial needs such as paying off high-cost debt or paying college tuition.

The interest rate on home equity-based borrowing is typically lower than that on credit cards and personal loans because the funds are secured by the equity. So the equity in your home can be a smart source of funds. Plus, interest on such borrowing is generally tax deductible if funds are used to improve the home.

Key Takeaways

  • Home equity is the current market value of your home, minus any liens such as a mortgage.
  • You can leverage your home equity in the form of collateral to tap into cash in the form of a home equity loan or a home equity line of credit.
  • When you put a down payment on a house of 20% or more, you automatically add to your equity in the home.
  • A smaller down payment means a larger mortgage and less home equity right off the bat.
  • The equity in your home may fluctuate for many reasons, including the rise and fall of overall market value in your community.

How Home Equity Works

If a portion—or all—of a home is purchased via a mortgage loan, the lending institution has an interest in the home until the loan obligation has been met. Home equity is the portion of a home's current value that the owner possesses at any given time.

Equity in a house is initially acquired with the down payment that you make when you buy the property. After that, a homeowner's equity continues to grow as mortgage payments are made. That's because a specific portion of each payment is assigned to reduce the outstanding principal that you still owe.

Another way equity grows is from the appreciation of your property's value.

How to Calculate Your Home Equity

Equity is the difference between what a home is worth and what's owed on a mortgage loan.

To calculate your home equity, first get an estimate of your home's value by taking a look at what homes like yours in your neighborhood have recently sold for. Say that figure is $350,000. In addition, obtain the figure for the balance of your loan from your lender. Again, let's say that's $150,000. With those figures, here's the calculation:

  • Equity = Value of home - loan balance
  • Equity = $350,000 - $150,000
  • Equity = $200,000

Example of Home Equity

If a homeowner purchases a home for $100,000 with a 20% down payment (covering the remaining $80,000 with a mortgage), the owner has equity of $20,000 in the house.

If the house's market value remains constant over the next two years, and $5,000 of mortgage payments are applied to the principal, the owner would possess $25,000 in home equity at the end of the two years.

If the home's market value had also increased by $100,000 over those two years, and that same $5,000 from mortgage payments were applied to the principal, the owner would then have home equity in the amount of $125,000.

Home equity is an asset and is considered a portion of an individual's net worth. However, it is not a liquid asset.

How to Borrow Against Home Equity

Unlike some investments, home equity cannot be quickly converted into cash. That's because the equity calculation is based on a current market value appraisal of your property. That appraisal is no guarantee that the property would sell at that price. 

However, an owner can leverage their home equity as collateral in a variety of ways to secure low-cost funds for their financial needs. Here are some of them.

Home Equity Loan

A home equity loan sometimes referred to as a second mortgage, usually allows you to borrow a lump sum against your current home equity for a fixed rate over a fixed period. Many home equity loans are used to finance large expenditures, such as home repairs or college tuition.

Home Equity Line of Credit

A home equity line of credit (HELOC) is a revolving line of credit, usually with an adjustable interest rate, which allows you to borrow up to a certain amount over a period of time. HELOCs work like credit cards, where you can continuously borrow up to an approved limit while paying off the balance.

Fixed-Rate Home Equity Line of Credit

When a borrower converts any or all of the funds secured through a home equity line of credit to a fixed rate, they have what's called a fixed-rate HELOC. The borrower will then pay off the fixed-rate amount over a specific period of time. Be sure to do your due diligence on this option because lenders may have different rules about how you can use it.

Cash-Out Refinance

A cash-out refinance refers to using your equity to get a new mortgage that's larger than the amount owed on your existing mortgage. Then, you pay off the existing mortgage and use the remaining money as needed. As with home equity loans and lines of credit, the funds are tax free because they're viewed as debt by the IRS, not income. The money can be used in any way you choose.

Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).

How to Use Home Equity

You can use the degree of your home equity and the funds you borrow on it in ways that benefit you financially.

  • Cancel your private mortgage insurance when your equity reaches 20%. Usually, PMI is automatically canceled once your equity reaches 22%. However, you can request its removal at 20%.
  • Pay off credit card balances that carry high interest rates. Rates on home equity borrowing are usually much lower.
  • Pay for bills or needed purchases with home equity funds instead of credit cards or loans to avoid incurring higher-cost debt. For instance, use the funds to pay for college tuition and expenses instead of taking out a student loan. Make needed changes to your home without taking out a higher-rate personal loan.

How to Increase Your Home Equity

Once you understand the benefits of home equity, you may want to focus on building it.

  • Make as large a down payment as possible on the home you're buying to accrue equity instantly.
  • Be aware of the type of mortgage you're getting. For instance, to build your equity consistently, avoid an interest-only loan. Payments for that go toward interest alone. No principal is paid off until a single lump sum is required.
  • Make every mortgage payment and try to pay more than the minimum amount required.
  • Stay in your home to take advantage of any increase in its value. The longer you're in it, the more likely you'll see some appreciation. That adds to your equity stake.
  • Consider making improvements to your home that add value to it. Not all changes a homeowner makes necessarily boost its value, so do your research.

Pros and Cons of Borrowing on Home Equity

Pros  Cons
Obtain needed cash and replace higher-cost payment methods Can burden owner with added debt and related costs
Lower interest rates than unsecured loans and credit cards Fees may apply that raise the effective rate
Interest is tax deductible if money is used for capital improvements Must restrict your use of funds
Borrowed funds are tax free

What Is a Home Equity Loan?

A home equity loan is money that is borrowed against the appraised value of your home. You receive the funds in a lump sum, and you are required to make monthly payments, as with any other type of loan. Basically, a home equity loan is a second mortgage on your house.

How Can I Get a Home Equity Loan?

You can get a home equity loan by contacting a lender who offers these types of loans. The first step is to get a professional appraisal of your home to find out its market value. If you have enough equity in your home to take out this type of loan, a lender will also check your credit and debt-to-income ratio. If you qualify for a home equity loan, your loan funds are usually delivered in a lump sum after the closing. Home equity loans are essentially a second mortgage on your house, with fixed-rate monthly payments.

What Is a Home Equity Line of Credit?

A home equity line of credit (HELOC) is similar to a credit card, acting as a revolving line of credit based on your home's equity. HELOC funds can be used when you need them, paid back, and used again. Often there is a 10-year draw period, where you can access your credit as needed, with interest-only payments. After the draw period, you enter the repayment period, where you must repay all the money you borrowed, plus interest.

How Much Equity Do I Have in My Home?

You gain equity in your home by paying down the principal in your mortgage over time. If you used a down payment to purchase your home, you likely have some equity in it, and with each mortgage payment, your equity grows. To figure out how much equity you have in your home, divide your current mortgage balance by the market or recently appraised value of your home.

The Bottom Line

Home equity refers to how much of the value of a home an owner controls compared to that controlled by the lender of the mortgage loan. It consists of any down payment made, the portion of the mortgage payment made that pays down the principal and any appreciation of the value of the home.

The benefit of building equity in your home, beyond ridding yourself of the loan you obtained to buy it, is the ability to borrow money against it.

Homeowners seeking money to meet their financial needs can take out a home equity loan or secure a home equity line of credit. They can also consider a cash-out refinance. Home equity borrowing costs are usually less than those for credit cards or personal loans.

In addition, the funds you obtain through a home equity loan, a home equity line of credit, and a cash-out refinance are tax free because they're borrowed money, not income.

Article Sources
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  1. Internal Revenue Service. "Publication 936 (2021), Home Mortgage Interest Deduction."

  2. Experian. "Do I Have to Pay Taxes on a Cash-Out Refinance?"

  3. Rocket Mortgage. "How to Get Rid of PMI."

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