A thorough understanding of all the terminology related to your mortgage is critical, but many borrowers have only a general idea of what home equity means in the arrangement. In addition, there are many other factors that affect – and are affected by – the value of your home’s equity. Some basic information should help you grasp the concept of home equity and how this amount factors into your financial situation. 

Definitions: Understanding home equity starts with learning the terminology to hear how some of the different concepts work. 

  • Home Equity: The equity in your home is the market value of your financial interest minus the balance of all debts against it; typically, the largest debt against your real estate will be your mortgage. Your home equity increases as you make mortgage payments against the balance due on the loan, but only a portion of the monthly amount you pay goes towards principal. The rest is paid to interest. Equity may also increase as your property appreciates in fair market value.
  • Collateral: Any asset that you pledge or offer as security for a loan is collateral as a guarantee if you default on repayment. Many lenders will require you to pledge some tangible collateral in order to grant you the loan, as a security against the risks if you don’t repay. A lender can seize the asset if you’re unable to pay on your loan.
  • Home Equity Loan: With this type of loan, your home’s equity stands in as collateral. Many homeowners use home equity loans to finance expenditures like home repairs, medical bills, debt pay down or education. When you arrange a loan against your home’s equity, a lien is created against your home.
  • Negative Equity: When the amount of your home loan is greater than its fair market value, you’re in a negative equity situation. The terms of your original mortgage aren’t set up to give you negative equity, but there are factors that can turn your equity upside down. Examples would be a volatile housing market and variable interest rates. Another reason you may end up with negative equity would be if you borrowed against your home on an equity loan and the market declines. 

Building Home Equity: While equity in your home is not a liquid asset, there are ways you can increase it to improve your financial outlook.

  • Paying your mortgage increases your home equity. A portion of your monthly mortgage payment goes toward interest, while the other pays your principal. With more frequent or larger payments, you can reduce your loan principal to increase equity.
  • Avoid a cash-out refinancing, which charges against equity.
  • Make home improvements that increase the fair market value of your home.
  • Arrange a cash-in refinancing, where you place additional funds down to reduce your mortgage amount.

Home equity is an important concept for a number of reasons, especially if you’re looking to obtain a loan to pay off debts, finance improvements, invest in education or for other purposes. These definitions and examples should help you in understanding how home equity works, but it’s smart to speak with a home equity specialist for more information.