What is equity?

A broad-based term that applies to many different areas of finance, equity, at its essence, is about ownership. For instance, equity represents ownership in a company through shares of stock. In real estate, equity is the ownership of a home.

People who pay a mortgage have a portion of the home’s total value as their own equity in their home. While the homeowner for legal purposes owns 100% of the home, they do not have all of the home’s value as equity. This is because the lender who issued them the mortgage has a lien on the property, as the home was used as collateral to issue a loan (the mortgage) to the homeowner. The homeowner will not have full equity in their home until the last mortgage payment is made and the home is paid off. When a mortgage is fully paid off, the homeowner has 100% of the home’s value as equity in the property.

Price is locked—value changes

On the day you buy a home, your price is locked in. The amount you pay for the house will always be the same. And on the day you buy your home, your property’s equity is equal to the debt you exchanged for it, the mortgage.

But as time goes on, the value of your property will change as the market takes new factors into account. If the value of the home rises over time, the homeowner’s equity increases. Conversely, if the value of the home falls over time, the homeowner experiences a decrease in their home equity.

Renovating

Any changes to the value of your home, higher or lower, from the day you purchase it are changes to the equity of the home on behalf of the owner. This goes back to the fact that the purchase price part of the formula is a constant, and as such the lender’s lien on the property is also fixed at the purchase price. All homeowners understandably want the value of their property to rise, which would bring increases in equity.

Increasing equity with mortgage payoff

Another function that increases equity is the gradual paying off of a mortgage. As amortization takes down the outstanding balance (principal owed) on the mortgage, the owner’s equity in the property increases by an equivalent amount. This highlights one of the main advantages to owning versus renting a home—a renter’s rent has no equity past the month lived in the residence. But a portion of a mortgage payment goes to the owner’s increasing equity stake. This higher equity stake also translates into a higher overall net worth for the homeowner.

A homeowner can also increase their equity faster by paying more than is owed on the mortgage each month. Any amounts paid over the required minimum go straight to principal decreases of the outstanding mortgage balance. But be warned—many lenders do not appreciate having a borrower pay their mortgage off faster, as it means less interest can be charged by the lender over the life of the loan.

A homeowner considering this option needs to weigh the benefits of increasing their equity faster against possible penalty fees their lender may charge. Be sure to examine your mortgage documents or contact your lender directly to inform yourself about potential penalties for mortgage prepayment.

An equity walkthrough

Let’s walk through a typical example of a homeowner’s equity several years into their mortgage.

Five years ago, Stephanie bought her first home for $280,000. She put $30,000 down and took out a mortgage for the remaining $250,000 of the purchase price. It’s a 15-year fixed rate mortgage at 4% interest.

Her amortization schedule shows that she still owes the lender $181,400 on the $250,000  mortgage loan.

Three years ago, Stephanie spent $15,000 to renovate her kitchen and patio. As she considers a move to another city for a new job, she has her home appraised, and the appraiser lists the value of the home at $320,000, reflecting some price increases in her zip code over the past five years and the value she added to the home through the renovations.

What is Stephanie’s current equity in her home?

She has accumulated equity in her home from three different sources.

1. The initial down payment of $30,000
2. The $15,000 in renovations (likely adding more than just $15,000 in value, but $15,000 minimum)
3. Local price increases in home values

To calculate her equity, we only need two of the figures listed thus far—the current value of the home and the amount still owed to the lender on the outstanding mortgage. Everything else is her equity. So we arrive at an equity value of:

$320,000 – $181,400 = $138,600 equity in the home

What can I do with my home equity?

Once you have built up some equity in your home, you can tap into it via several methods. In the case of Stephanie above, the $138,600 is the amount a lender would calculate as her equity in the home should she seek out a HELOC loan, refinance the original mortgage, or go to sell her home on the market. In all cases except selling the home, the owner can typically only tap into a portion of their equity, in the range of 50%-80%.

These options are all available provided that the mortgage on the property has been paid without interruptions since the loan was first issued and the homeowner is in good standing on the mortgage. There are also time restrictions on how soon after a mortgage is first issued the homeowner can refinance or obtain a HELOC, usually anywhere from one to three years.

(For further reading on equity, check out these strategies on managing equity.)

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