What is home equity, and how does it work?

Your home can be more than a place to live. It may become a valuable asset over time. Home equity is the difference between your home’s current market value and the amount you owe on your mortgage. If you qualify and it fits your financial situation, you may be able to access some of that equity. As you pay down your loan and the value of your home changes, your equity changes, too. Many homeowners choose to use their equity when they want to cover major expenses or consolidate debt.

Knowing your options for accessing your home equity can help you consider whether using yours is right for your goals and situation. This guide covers the basics of home equity, so you can decide if you should tap into yours:

• What home equity is and how it works
• How to calculate and build equity
• Ways to access your equity
• Common ways to use home equity
• Borrowing guidelines, financial risks and considerations
• Terms to know
• FAQs

What is home equity?

Home equity is the difference between how much you owe on your mortgage and how much your home is worth. It’s the portion of the property you own outright. Over time, your equity may grow as you make mortgage payments, assuming your home’s value stays the same or increases. Your equity also can change if the value of your home changes. This process can continue until you pay off the mortgage or sell the property.

The equity you have in your home can be a valuable financial resource. Many homeowners access theirs through borrowing or by selling their home. They commonly use the money to help fund big goals, consolidate debt or pay for major expenses.

How to calculate your home equity

You need 2 numbers to calculate your home equity: 

1. Your home’s current market value.
2. How much money you still owe on the mortgage loan.

The basic formula for figuring out your home equity is:

your home’s current market value - your remaining mortgage balance = your home equity

As a representative example, let’s say your home is currently valued at $400,000 and you owe $250,000 on your mortgage. Your home equity would be $150,000 (that’s $400,000 minus $250,000). That works out to a 37.5% equity stake in your home ($150,000 divided by $400,000 times 100). 

How does home equity grow?

Home equity grows and changes as a few different factors work together. Some, like paying down your principal or choosing home improvements, may be within your control. Others, like local property values and market demand, aren’t.

Factors you may be able to influence

Market factors outside your control

Home equity approval checklist

Before you apply for a home equity loan or line of credit, confirm that you have:

• An estimate of your property’s current market value, which the lender may verify through an appraisal or other valuation during the underwriting process
• About 20% equity in your home, based on your home’s value and your remaining mortgage amount
• A good credit score (usually 670 or higher)
• A debt-to-income ratio that shows you could manage the payments
• A clear plan of how you’ll use the funds and how you’ll pay them back

Ways to access your home equity

Building home equity is only part of the equation. The other part is knowing how to access that equity. For example, you might choose to get a lump sum or a line of credit. Here are your options for tapping into home equity and how they work:

Home equity loans (HEL)

A home equity loan lets you borrow money in a lump sum upfront, which you repay over time at a fixed interest rate. A home equity loan is often called a second mortgage because it’s a separate loan from your primary mortgage. Your monthly payment stays predictable for the life of the loan.

Home equity lines of credit (HELOCs)

A HELOC is a revolving line of credit secured by your home. It can feel similar to using a credit card, but it carries different risks. Instead of a lump sum, you can draw money as needed, up to a set limit. HELOCs typically carry a variable interest rate, so your payment can change based on current interest rates and when the draw period ends. The lender also may freeze or reduce the line of credit in certain situations.

Cash-out refinance loan

With a cash-out refinance, you replace your existing mortgage with a new, larger one and take the difference in cash. Rather than adding a second loan on top of your mortgage, you end up with one new loan and new terms, plus a lump sum of money you can use. Keep in mind that this method involves closing costs, and you may end up with a new interest rate.

Home sale

Selling your home is the most direct way to access your equity. When you sell, you pay off your mortgage and other selling costs first. What’s left becomes cash, which many homeowners put toward their next home purchase.

Comparing your options

Home equity loans, HELOCs and cash-out refinance loans can help you access your home’s equity, but they all work differently. Comparing how they handle payouts, repayment and flexibility can help you understand which options may align best with your needs.

3 common ways to use home equity

Once you’ve decided how to access your equity, the next question is what you’ll use it for. Here are some common ways homeowners use their home equity:

1. Paying for planned projects

Home improvements are a common use of home equity. Popular projects include kitchen remodels, room additions or a new roof. Many of these projects also can raise your home’s value. That means you could be building more equity even as you spend it.

2. Covering unexpected expenses

Some homeowners consider using home equity for high, unexpected costs or emergencies, like medical bills, urgent repairs or expenses during a job loss. Before using your home as collateral, compare other options, the total cost, the payment amount and whether repayment fits your budget. Because the loan is secured by your home, a home equity option may offer a different rate or borrowing limit than an unsecured credit card or personal loan. Be sure to compare rates, fees, terms and the risks before deciding.

3. Consolidating debt

Some homeowners use equity to consolidate higher-interest debt, like credit cards or personal loans. Debt consolidation may let you combine several debts into one payment. Still, it can also change your repayment timeline and total borrowing cost. Because your home secures the loan, take time to compare the full cost, repayment terms and risks before deciding if using your home equity for debt consolidation is a good fit for your situation.

Whatever you decide to use your equity for, it helps to have a clear purpose before you borrow. Home equity is a flexible resource, but like any loan, it comes with terms and repayment expectations worth understanding upfront.

Home equity borrowing guidelines, financial risks and considerations

Before tapping into your equity, it helps to understand the borrowing guidelines, financial risks and considerations. Lenders use certain guardrails to decide how much you can borrow. There are also some risks that come with using your home as collateral. 

Keep these guidelines, financial risks and considerations in mind as you consider whether using home equity fits your situation:

A common 80% loan-to-value guideline

Many lenders follow a general loan-to-value (LTV) guideline to help manage the risk of lending against a home’s full value. They may let you borrow up to about 80% of your home’s value. That generally leaves about 20% equity in your home as a cushion. This isn’t a fixed rule. It can vary by lender, loan type and your credit profile, so be sure to confirm the specifics with a loan officer.

Understanding default and foreclosure risks

Borrowing against your home means your home secures the loan. If you can’t keep up with your payments, your lender has the right to foreclose on your home because you used it as collateral. In a foreclosure, the lender takes ownership of the property to recover the funds that are owed. This is true of any loan that uses your home as collateral, including your primary mortgage.

Potential tax implications

In some situations, the interest that’s paid when borrowing against home equity may have some tax implications. Tax rules can vary, so many homeowners choose to consult a qualified tax professional for guidance so they’ll know what they can expect.^{Footnote [1]}

Home equity terms to know

As you look at different options for accessing your home equity, you’ll likely run into some important terms. Here are a few common ones you may see and what they mean:

• Loan-to-value ratio (LTV) is a comparison of how much money you’re borrowing and your home’s market value. For example, a $75,000 loan on a $100,000 property would be a 75% LTV.
• Combined loan-to-value ratio (CLTV) is similar to LTV, but it’s used if there are multiple loans on your property. To determine your CLTV, add up all your loan balances and divide that number by your home’s value.
• Debt-to-income ratio (DTI) is the share of your monthly income that goes toward existing debt payments. DTI is one factor used to help determine how much money you may be able to borrow. Lenders divide your total monthly debt payments by your gross monthly income to determine your DTI. For example, if your monthly debts total $2,200 and your gross monthly income is $6,500, your DTI is 34%.
• Draw period is the span of time during a HELOC when you can borrow funds as needed.
• Repayment period is the span of time after a HELOC’s draw period ends. You can’t draw any new funds and must repay what you’ve already borrowed.
• Prime rate is a benchmark interest rate that many lenders use as a starting point for variable-rate products like HELOCs. When the prime rate moves, your HELOC’s rate may move with it.

Home equity FAQs

Who’s eligible for a home equity loan or line of credit?

When reviewing home equity applications, lenders look at several factors like your credit history, income, mortgage balance and how much equity you have. They review your full financial picture, not just a single number. Requirements usually vary by lender and loan type.

How can I calculate my home equity?

Subtract what you still owe on your mortgage from your home’s current market value. The result is your home equity. That can be expressed as a dollar amount or as a percentage of your home’s total value.

What are the most common uses for home equity?

Homeowners commonly use equity for home improvements, large and unexpected bills or debt consolidation. Many people use their equity for the down payment on their next home.

Is there anything you can’t use your home equity for?

Borrowers typically have flexibility in how they choose to use their home equity funds. Still, restrictions can vary by lender, product and loan agreement. Review your terms before you borrow so you can understand your options. Since the home itself secures the loan, many people prefer to use their home equity for things that build long-term value.

How can I increase my home equity fast?

There’s no guaranteed way to build equity quickly. The ability to build home equity depends on your mortgage loan and your local housing market. Some homeowners try to speed up the process by making extra principal payments, steady on-time payments and home upgrades that may raise their appraised property value.

Tap into your home’s equity with help from Navy Federal Credit Union

If you’re considering tapping into your home’s equity, we can help you explore home equity loan, HELOC or cash-out refinancing options. You can use our home equity calculator to see how much of your home’s equity you might be able to access with a home equity loan or line of credit, and calculate what your loan payments could be. Continue learning about home equity, home improvements, debt consolidation and more in our MakingCents financial education library.