Here's What You Need to Know About Home Equity and The Best Ways to Use It

One of the biggest advantages of homeownership is building equity over time. But what really is home equity? Read on to learn what it is, how it works, and the smartest ways you can use it to your advantage.

What is home equity?

In simplest terms, home equity is a homeowner's most valuable asset. It is the portion of your property that you truly “own”. Because although you’re considered the homeowner, if you borrowed money to purchase the home, your lender has an interest in the property until you pay off the loan. Your equity can be one of your biggest financial tools as a homeowner because you can tap on it later in life and make it an excellent source of funds.

According to the recent Homeowner Equity Insights Report by CoreLogic, U.S. homeowners with mortgages (roughly 63% of all properties) have seen their equity increase by a total of nearly $590 billion since the first quarter of 2019, an increase of 6.5%, year over year. This means that in the first quarter of 2020, the average homeowner gained approximately $9,600 in equity during the past year. 

And even with the impact of the COVID-19 pandemic in the latter half of the first quarter of 2020, home prices continued to rise, which added to borrower equity through March. It’s a huge win for many homeowners, especially those who are looking to sell their homes this year.

3 Ways You Can Leverage Homeowner's Equity:

1. Home equity loan - This is also referred to as a “second mortgage” because the two loans function very similarly. With this loan, you’re borrowing against the equity you’ve built up in your home so the amount that you can borrow may be limited by how much you’ve paid down in your mortgage.

2. Home equity line of credit (HELOC) - This is the most flexible among the three options. With HELOCs, the loan is divided into two distinct pay periods: the draw period and the repayment period.

3. Cash-out refinance - In this kind of refinance, you borrow more than what you owe and receive the difference in funds, which can be used as you see fit.

4 Smart Ways to Use the Equity of Your Home

If you've built up equity in your home over the years, there are several ways to use that asset to your advantage:

1. Make home renovations and upgrades.

One of the most common uses of home equity is to invest in home improvements, especially those upgrades that will increase the value of your home and build more equity as a result. Renovation projects such as upgrading a kitchen or bathroom, adding more livable space, or updating appliances, can make your home more comfortable and elevate its condition so it will be more attractive to potential buyers. These renovations are a good return on investment since your home will sell quicker and for more money.

Just remember that there are some improvement projects that can actually lower your home's value so be careful before you borrow against your equity with this purpose in mind.

2. Create an emergency fund.

One of the easiest and most convenient ways for homeowners to get cash is to tap into their home equity. And it's especially helpful if you experience a financial emergency and your emergency fund has been depleted. Your home’s equity can serve as a low-interest alternative to credit cards or payday loans.

Experts suggest that by setting up a HELOC before you need it, you’ll be able to access your money faster and be able to qualify for one once an emergency arises.

3. Buy a second home or an investment property.

If you've owned your home for a few years, there’s a good chance you’ve already built up a reasonable amount of equity. This can be a valuable resource if you’re planning to purchase an investment property. When you use equity to buy another home, you’re exchanging that debt for another asset that can potentially produce income. Just remember that real estate investing is a risky business so make sure to weigh in all the pros and cons before tapping into your equity to buy another property.

4. Pay off student loans and other high-interest debts.

Equity is a tool that homeowners can use to improve their financial situation. And aside from using it for upgrades and buying a second home, you can also use it to pay off higher interest credit cards and student loans. Some cash-out refinance loans, such as student loan cash-out refinance, are specifically priced to be used to consolidate your student loan debt and mortgage into better terms. 

Likewise, because of its lower rates, a debt consolidation loan using your equity may be a more attractive option than paying higher credit card balances. It can save you money to be spent in interest over the life of the balance, depending on your debt and loan scenario. It can help improve your overall financial health as long as you're being disciplined and not accruing additional debt while paying off the existing balance.

Bottom Line

Just remember that the biggest risk of tapping home equity is that your home serves as the loan collateral. This is why experts strongly advise against using it to buy a car or fund any expensive luxury or vacation. But at the end of the day, the smartest way to leverage equity still depends mainly on what you want or need to do with the funds, your credit score, financial situation, and other factors regardless of which option you choose.