A Comprehensive Guide to Home Equity

Remember the excitement when you bought your first home? You were eager to start building your life in it. What you might not realize is that you also began the process of building home equity! Home equity is a significant asset that offers opportunities for financial flexibility. In this guide, we’ll explore what you need to know about home equity — what it is, how to calculate it and how you can leverage it responsibly and effectively.

What Is Home Equity?

Home equity is the difference between the current value of your home and the amount you still owe on your mortgage. But while that’s the simple definition, it actually means a lot more — it’s an important financial tool. Home equity represents both what you've paid into your loan and any increase in your home's value. And once you’ve accumulated enough equity, you can potentially unlock it for cash.

How Does Equity Work?

Home equity builds up over time, but thanks to your down payment, you’ll have some as soon as you close your home.

For example, if you put 10% down on a $500,000 home (which equates to $50,000), you will have $50,000 equity upon closing. You could also say you have 10% equity in your home.

As you make your regular monthly mortgage payments and your principal balance decreases, your home equity gradually increases. Once you finish paying off your mortgage, your home equity will be 100%.

Additionally, an important factor that plays a role in how much equity you build is the market value of your home.

Today’s Market Value and Your Home Equity

Home equity is tied to your home’s current market value. As your home’s value changes, so does your equity. If it increases, your equity will increase. If the home depreciates for any reason, your equity can decrease.

Calculating Your Home Equity

Let’s break down the formula for calculating your home equity:

Current Market Value - Outstanding Mortgage Balance = Home Equity

Let’s say you purchased a home for $500,000 and put $50,000 down, like the example above. This would have left you with a $450,000 mortgage at closing.

It’s been a few years since you purchased your home, and now your mortgage balance is $350,000. In addition, your home’s value has increased to $50,000 due to market appreciation.

Let’s plug the numbers into the formula:

$550,000 (Current Market Value) - $350,000 (Outstanding Mortgage Balance) = $200,000 (Home Equity)

Your home equity is $200,000. This number includes both the initial down payment ($50,000), the equity gained through mortgage payments ($100,000) and the equity gained through home value appreciation ($50,000).

Curious about what your home could be worth? Use our home value estimator to see an instant estimate of your home’s current value and view recent home sales in your area.

Factors That Influence Home Equity

Home equity is influenced by several factors, including:

• Mortgage payments
• Rising property values, including real estate trends or economic conditions that may influence a property’s value
• Renovations or upgrades that enhance a home’s worth
• Your initial down payment amount

Keep in mind that market conditions can sometimes lead to decreases in home value, which could reduce equity value.

How to Build Home Equity

As you can see, the more equity you have, the higher percentage of the home you actually own outright. And home equity gives you access to cash-out options, which can be used for various purposes, such as funding home renovations, covering education costs, paying off debts or managing other financial goals.

Since home equity is such a valuable asset, consider the following ways you could build home equity faster:

Increase your mortgage payments: Making even slightly greater payments on your principal balance for your current mortgage will help you build equity faster. You could also make an extra payment each year.

Refinance to a shorter term: If you have a 30-year mortgage, consider refinancing to a 15-year loan. While this would likely increase your monthly payments, you could end up with a lower rate, save on interest, pay off your mortgage sooner and build equity more quickly.

Enhance your home strategically: Some renovations, like a kitchen remodel or the addition of a new bathroom (resulting in higher total square footage), may increase your home's value, boosting your equity. However, not all projects have a good return on investment. If increasing your home equity is your goal, do your research to see if your project will pay off.

Keeping your home: Even if you don’t make any changes, the longer you keep your home and pay your mortgage, the more equity you'll accumulate. Consistent payments over time chip away at your principal balance.

Accessing Your Home Equity

A home equity loan, cash-out-refinance and a home equity line of credit (HELOC) are three options for putting home equity to work for you.

Home Equity Loan

A home equity loan lets you borrow money by tapping into your home equity. Since the loan is added on top of your mortgage, it’s often called a “second mortgage.” You’ll be responsible for making your current mortgage payment, as well as the additional home equity loan payment.

With a home equity loan, you'll receive a lump sum of funds upfront and repay your loan over a set period, with payments spread evenly across the loan term.

A few of the benefits of a home equity loan are:

• You can access your funds immediately
• Your current mortgage remains untouched
• You have predictable monthly payments throughout the life of the loan since it typically comes with fixed interest rates
• You may qualify for a tax deduction if you use the funds for home improvements*

Cash-Out Refinance

A cash-out refinance replaces your existing mortgage with a new loan for a higher amount than you currently owe. You’ll receive the difference in cash, which you can use for various purposes.

Unlike a home equity loan that adds a second mortgage, a cash-out refinance streamlines everything into a single, new mortgage with one monthly payment. This option can be ideal for homeowners who want a lump sum of cash while also refinancing their existing mortgage to potentially lower their interest rate or adjust their loan term.

Home Equity Line of Credit (HELOC)

A HELOC works like a credit card tied to your home’s equity. You can borrow as needed, up to a set limit, during the initial stage; this is known as the draw period. During this time, you're typically only required to pay interest. After the draw period ends, you'll begin paying both principal and interest, with payments spread over the remaining loan term. Keep in mind that the amount you owe each month can increase substantially after the initial period ends.

While a HELOC may appear to offer flexibility with the option to draw funds as needed, it will typically come with an adjustable interest rate, which will fluctuate over time, depending on the whims of the current market. This unpredictability can make budgeting more challenging compared to a home equity loan or a cash-out refinance, both of which offer a fixed rate and consistent monthly payments.**

How Can You Use Your Home Equity?

There are several common ways homeowners use the equity in their homes:

Consolidate Debt

Managing multiple high-interest debt accounts, like credit cards with revolving balances or personal loans, can be stressful. You can use a home equity loan to consolidate that debt into a single fixed monthly payment with a potentially lower interest rate. This could simplify your finances as well as reduce how much you owe each month as you pay off your bills at a more favorable rate.

Renovate Your Home

Want to add a pool? Or maybe you’d like to finally install central air or turn your kitchen into a chef’s playground? Cashing in some of your home equity can help you fund significant home improvements while potentially increasing the resale value of your property.

Fund Major Expenses

Whether it's funding your child's education or making a high-ticket purchase, your home equity can be a valuable resource. It can provide needed funds without requiring you to deplete your savings or rely on high-interest credit cards.

Cover Emergency Expenses

If there’s one thing that’s sure in life, it’s to expect the unexpected. Home equity can be accessed for cash to cover medical bills, emergency home repairs or other unforeseen expenses.

Invest in the Future

Some homeowners use their home equity to fund a new business venture or purchase an investment property.

Considerations Before Tapping Into Your Home Equity

Accessing your home equity is a significant financial decision. While it offers many benefits, it’s important to consider the following:

Loan rate, term and closing costs. Compare interest rates from different lenders. For a home equity loan or cash-out refinance, you’ll also want to think about the loan term and how it aligns with your long-term goals. Keep in mind that for any of these options, you’ll have to submit an application, go through underwriting and be responsible for closing costs, similar to your original mortgage.

Your home is used as collateral. Like any loan, it’s essential to make your payments on time. Since your home is used as collateral, missing payments could put your property at risk of foreclosure.

You will have debt. Tapping into your home equity increases your debt. Evaluate your budget to ensure you can handle your new monthly payment. Keep in mind that too much debt may also affect your ability to secure financing for other purposes in the future.

Some home equity is required. To qualify for a home equity loan or cash-out refinance, you'll typically need at least 15% home equity remaining after taking any cash out.

Paperwork is part of the process. Just like when applying for your initial mortgage, you'll need to submit all the required documents to get approved for a home equity loan or cash-out refinance.

Your spending. If you plan to unlock your home equity to consolidate high-interest debt, be sure to take a close look at your spending habits. You want to avoid falling into the same cycle of debt after consolidating it.

How Would You Use Your Home Equity? Explore Your Options With Pennymac

Making the most of your home equity can be a smart financial move as long as the path you choose fits your needs and life plans. Connect with a Pennymac Loan Expert today to explore what a home equity loan or cash-out refinance can do for you.

*Consult a tax adviser for further information regarding the deductibility of mortgage interest and charges.

**Although Pennymac does not currently offer HELOCs, we are available to answer any questions you have about how they work or what your other options are. Don’t hesitate to get professional advice. Contact a Pennymac Loan Expert to determine just what you should be doing with your home equity.

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