Home Equity Explained: What It Means and How It Works

Home equity is the portion of your home that you actually own. It’s the difference between what your home is currently worth and what you still owe on your mortgage.

The formula is simple:
Home Value − Mortgage Balance = Home Equity

For example, if your home is worth $500,000 and you still owe $400,000 on your mortgage, your home equity is $100,000.

That number isn’t fixed. It rises and falls as your home’s value changes and as you pay down your mortgage each month. Once your mortgage is fully paid off, you own your home outright and your equity equals 100% of its value.²

Before you can calculate your equity, you need a reliable home value figure. Here are your main options:

• Hire a licensed appraiser. This is the most accurate method and is required by lenders before equity is made available to you. Expect to pay between $250 and $600 depending on the type of appraisal you’re looking for (traditional, drive-by or desktop — which is based solely on floor plans, property records and local market data).³
• Research comparable sales. Look at recent sale prices for comparable homes in your neighborhood. Look for similar square footage, age, condition and location. Real estate sites provide estimates, but treat these as ballpark figures rather than guarantees.
• Ask a real estate agent. A local agent can run a free Comparative Market Analysis (CMA), which uses recent sales data to estimate your home’s current market value.

Every mortgage payment you make is split between principal and interest. Only the principal portion reduces your balance and builds equity. Interest, taxes and insurance do not contribute.

In the early years of a mortgage, most of your payment goes toward interest. As your balance decreases, that ratio shifts and more of each payment goes toward principal, building equity faster. This is called mortgage amortization, and it’s why homeownership tends to become a more powerful wealth-building tool the longer you stay in a home.

See how your equity grows over time with Blue Water’s free mortgage and amortization calculator.

Here’s an example:

You take out a 30-year mortgage for $400,000 at a fixed rate. In year one, a large portion of your monthly payment goes to interest with relatively little reducing your principal. By year 20, that ratio has flipped and the majority of each payment goes toward principal, and your equity is growing significantly faster each month.

Making extra principal payments speeds up this process.

How Appreciation Increases Home Equity
When your home’s market value rises due to a strong local real estate market, neighborhood improvements or renovations you’ve made, your equity increases even if your mortgage balance hasn’t changed at all.

That means if your mortgage balance stays at $300,000, but your home’s value rises from $400,000 to $450,000 over three years, your equity grows by $50,000 without you doing anything.

This is one of the main reasons homeownership has historically been one of the most reliable long-term wealth-building strategies available to everyday Americans.⁴

Why Equity Can Also Decrease

Equity isn’t guaranteed to grow. These two scenarios can actually cause your home equity to take a hit.

Home values fall. If your home loses value faster than you’re paying down your mortgage, your equity decreases. In severe cases such as the 2008 housing crisis,⁵ homeowners can end up “underwater,” meaning they owe more than the home is worth.

You borrow against it. Taking out a home equity loan, HELOC or cash-out refinance increases your total debt, which reduces your equity. This isn’t inherently bad, as it depends entirely on what you do with the funds, but it’s important to understand the tradeoff.

Both the dollar amount and percentage of home equity matter, and they tell you different things.

• Dollar amount tells you how much wealth you’ve built in your home in absolute terms. This is what you’d pocket if you sold today (minus selling costs).
• Equity percentage tells you how much of your home you own relative to its total value. Lenders pay close attention to this number, specifically your loan-to-value ratio (LTV).⁶

LTV = Mortgage Balance ÷ Home Value × 100

A lower LTV means more equity, less risk for the lender and better borrowing terms for you.

Most lenders won’t let you borrow against 100% of your equity. The standard limit is 80% of your home’s value, minus what you owe.⁷

Here’s how to calculate it:

(Home Value × 0.80) − Mortgage Balance = Maximum Borrowable Equity

For example, say your home is worth $500,000 and you owe $300,000.

($500,000 × 0.80) − $300,000 = $400,000 − $300,000 = $100,000 available to borrow

Even though your total equity is $200,000, lenders will typically cap your borrowing at $100,000 to ensure you retain at least 20% equity in the home.

Once you’ve built enough equity, you have three main ways to access it. Each one reduces your equity in the short term, so the goal is making sure what you do with the funds is worth the tradeoff.

• Home Equity Loan: Delivers a fixed lump sum with predictable monthly payments over a set term. This is a preferred option when you know exactly how much you need and want the certainty of a fixed rate.
• HELOC: Works like a credit card secured by your home. You draw what you need during a draw period, then repay it during a repayment period. Variable rates mean your payment can fluctuate, which is helpful for flexibility but worth watching carefully.
• Cash-Out Refinance: Replaces your existing mortgage with a larger one and puts the difference in your pocket. One loan, one payment is best when current rates are favorable and you want to access a significant amount of equity without adding a second loan.

Here are some of the best ways to make your money work for you:

• Buy a New Home: If you’ve lived in your home for a few years and are considering a move, you can leverage your home equity to help fund your next home purchase. Let’s say your home is worth $600,000, and you’ve built $100,000 in equity. While you may not receive that entire $100,000 due to fees, such as realtor’s commission or closing costs, you’ll likely walk away from the sale with a substantial amount of money that you can then use to make a down payment on your next home. And by making a larger down payment, you’ll be able to lower your monthly mortgage payments and interest paid over time and increase your home equity.
• Increase Retirement Savings: Homeowners aged 62 and older can leverage their home equity to fund their retirement savings using a reverse mortgage.⁸ Using your home equity to increase your retirement savings can be a smart way to grow your wealth and secure your financial future by diversifying your portfolio and mitigating your risk of fluctuations in the market.⁹ As with any major financial decision, be sure to do your research and consult a qualified loan officer before pursuing this option.
• Invest in Home Improvements: Want to remodel your home, but don’t have the cash on hand for renovations? Consider using your equity. You can leverage your home’s equity to make improvements to your property, which not only helps you save on remodeling costs but can also increase your home’s value over time, increasing your equity and potential profits should you eventually choose to sell.
• Consolidate High-interest Debts: A home equity loan, home equity line of credit (HELOC) or cash-out refinance can be a smart way for homeowners to consolidate debt, often at a lower interest rate. For example, credit cards typically carry interest rates between 15% and 25%,¹⁰ while the average home equity loan and HELOC interest rates currently sit below 10%.¹¹ In addition to being a good way to lower interest rates, consolidating debt through refinancing reduces the number of monthly payments you need to keep track of, can increase your potential tax deductions and can improve your credit score.
• Eliminate Private Mortgage Insurance (PMI): You can leverage your home equity to break free from PMI. By refinancing, you have the opportunity to secure a new loan with better interest and/or lower monthly payments.
• Cover Higher Education Costs: Whether you’re saving for your child’s future, your kids are currently in college or you’re looking to pay off your own student debts, you can leverage your home equity to cover higher education costs. Refinancing can help reduce your interest rates and leave you with more cash on hand to pay for tuition or pay off student debt.
• Invest in Real Estate: Investing in real estate can be a great way to earn passive income and diversify your portfolio,¹² but it generally requires considerable resources. The good news is that homeowners can leverage their home equity to fund investment property purchases, making it easier for them to achieve their financial goals.
• Pay for Medical Expenses: Many homeowners choose to leverage their home equity to pay off medical bills because home equity loans typically have lower interest rates and lower monthly payments than credit cards.
• Create an Emergency Fund: The general wisdom is that you should have three to six months’ worth of living expenses in your emergency fund at any given time.¹³ Using your home equity to set aside extra money in case of emergency is a good way to protect yourself for the future.

Leveraging your home’s equity can be a fantastic way to achieve your financial goals; however, there are certain uses that can set you back in the long run. To protect yourself from potentially negative repercussions, avoid using your home equity for the following:

• Vacations: A lavish vacation can be exciting and relaxing, but not if it means having to pay higher monthly bills for years to come. Plus, if you can’t afford these increased monthly payments or consistently make them on time, you could risk damaging your credit score or even foreclosure.
• Everyday Expenses: Similar to paying for a vacation, using your home equity to cover day-to-day expenses such as groceries, gas or social outings might provide immediate relief, but they can also cause problems for you further down the road in the form of higher monthly payments.
• Weddings and Other Special Events:Between venues, catering, entertainment and more, the average wedding costs $36,000¹⁴ — a substantial chunk of change. While it can be tempting to use your home equity to fund a wedding or other special event, the long-term costs simply aren’t worth a single day of fun and can increase your risk exposure.
• Depreciating Assets: Your home is an appreciating asset, meaning it increases in value the longer you own it; the same is true for real estate, which is why purchasing an investment property can be a smart way to leverage your home equity. Other assets, such as automobiles, furniture, electronics and machinery are considered depreciating assets and should be avoided at all costs.

If you want to speed up your equity growth, these seven approaches are proven to help:

1. Make a larger down payment. More equity on day one means less interest paid and a stronger borrowing position from the start.

2. Pay more than the minimum each month. Even an extra $100 to $200 per month toward principal compounds meaningfully over a 30-year loan.

3. Set up bi-weekly payments. Paying half your monthly mortgage every two weeks results in one extra full payment per year, trimming years off your loan term.

4. Refinance to a shorter loan term. A 15-year mortgage typically carries a lower rate than a 30-year, and a larger share of each payment goes to principal. Your monthly payment will be higher so make sure the math works for your budget.

5. Make value-adding renovations. Improvements that increase your appraised value build equity without reducing your mortgage balance. Research ROI before you start as not all renovations pay off equally.¹⁵

6. Stay in your home for the long term. Appreciation compounds over years, and amortization accelerates in the later years of a mortgage. Both forces favor homeowners who stay put.

7. Eliminate PMI as soon as possible. PMI adds to your monthly payment without contributing to equity. Once your loan balance reaches 80% of your home’s original value, request its removal.¹⁶

Q: What is home equity?
A: Home equity is how much of your home you actually own. It’s the difference between what you owe on your mortgage and what your home is currently worth.

Q: How do I calculate my home equity?
A: Use this formula:

Home Value − Mortgage Balance = Home Equity.

For example, a $450,000 home with a $280,000 mortgage balance = $170,000 in equity.

Q: How do I calculate my equity as a percentage?
A: To calculate your home equity as a percentage, divide your equity by your home’s value and multiply by 100. Using as an example a $450,000 home with a $280,000 mortgage balance:

$170,000 ÷ $450,000 × 100 = 37.8% equity.

Q: How can I best leverage my home equity?
A: Here are some smart ways to leverage your home equity:

• Buying a new home
• Adding to your retirement fund
• Making home improvements
• Consolidating high-interest debts
• Removing PMI
• Paying for higher education
• Real estate investing
• Paying off medical expenses
• Protecting yourself with emergency funds

Q: How can I quickly build home equity?
A: Your home equity builds when you pay off your mortgage or when your home increases in value. To build equity faster, consider doing the following:

• Making a larger down payment
• Paying off your mortgage
• Paying more than the minimum amount for your monthly mortgage payment
• Increasing the value of your home with renovations
• Refinancing to a shorter loan term
• Staying in your home for 5+ years

Ready to understand your equity options and find the right path forward? Contact a Mortgage Expert