When we look at home equity, we instantly think of home equity loans or home equity lines of credit. There is a reason for that, and we’ll get to it in a bit. Firstly, however, homeowners must understand what home equity is. Home equity can be defined as the interest a homeowner has in a home. In other words, how much money did the homeowner pay for the house so far? The reason we say so far is that home equity is a value that is affected over time.
Regarding homebuyers that decide to purchase a home, a high percentage of them need a loan, or mortgage, to make the purchase. If they're buying a home and don't have very much money for the down payment, they can take out a mortgage. Now, we can already talk about the homeowner’s home equity regarding the down payment. The down payment is how home equity starts, but let’s go into details about this.
We already established that a vast majority of homebuyers take out mortgages to purchase a home. When they take out a mortgage, they also pay a down payment for the house. That is the first financial addition that goes into home equity. The homeowner then makes monthly payments into the mortgage or loan that proportionally cover the premium, so the home equity increases. With each mortgage payment, the homeowner owns more and more of the house that he/she is purchasing. This is why home equity is, in reality, the portion of the home’s value that the homeowner owns at any given time.
An added benefit of home equity is that the value of the property can appreciate over time, which will increase the home equity as well. As the property’s value appreciates, the portion of the property already paid and part of the home equity will appreciate as well. This can mean that when a homeowner takes out a loan for a property valued at $300,000 and pays $100,000 towards a down payment, that downpayment becomes equity in the home. Then, let’s say they pay around 60% of their mortgage payment over a period of time which would increase their home equity to $220,000, without the potential of appreciation. However, with appreciation, they could find out that the property’s value increased to $350,000. Their home equity, after 60% of their loan obligation is paid, increased to $270,000 because of the appreciation.
One significant advantage of home equity happens when appreciation rates increase, as mentioned above. There are, however, many ways in which home equity has a significant effect.
In the beginning, we mentioned taking home equity loans, and so on. In fact, there are several types of loans that are impacted by home equity.