What is Home Equity?
What You Should Know
- Home equity is the amount of your home that you own.
- It is calculated as the current market value of your property minus any mortgage debts.
- It typically increases over time with property appreciation, mortgage payments, or even if you make a higher down payment.
- You can borrow against your home equity to finance your retirement or if you need cash.
What is Home Equity?
Home equity is the amount of your home that you own. In other words, it's the current market value of your property minus any debt or liens attached to it. There are multiple ways to gain home equity, such as paying off your mortgage. In most cases, home equity is an owner's greatest asset. Please continue reading to learn all things about home equity and how to use it wisely.
How Home Equity Works
If you purchase a home with a mortgage, your lender owns a percentage of your house until you fully pay off the mortgage. The remaining portion of the home belongs to you; this is known as home equity.
For example, when buying a house with a conventional mortgage, you have a 20% down payment. When you first buy the house, this 20% is the amount of the home that you own; it is your home equity. If we apply this scenario to a $100,000 home, your home equity is $20,000 (20%*100,000).
Initially, your home equity is the result of your down payment. However, as we will discuss later, other factors cause your home equity to increase over time.
How to Calculate Home Equity
To calculate your home equity, you need to know two things; your home's current fair market value and the total balance of your mortgage or any other liens against your property. A lien can be considered a purchase loan, second mortgage, or any similar financial product that is secured by your home.
A real estate agent can estimate the fair market value of your home through comparative market analysis. You subtract your mortgage balance from your home market value to find your home equity with this information. To find your outstanding mortgage balance, you can use a mortgage amortization calculator or talk to your existing lender.
How to Build Home Equity
Higher initial down payment
This is the fastest way to build home equity. The more money you invest in your home, the higher home equity you receive. As mentioned before, if you put 20% down when purchasing a $100,000 home, your initial home equity is $20,000.
Additionally, paying a higher down payment upfront will cause you to spend less interest throughout your mortgage. As a result, you'll end up building home equity faster. A higher down payment may also help you get the best mortgage rates in Canada.
Property value appreciates
Your equity builds as the value of your house rises. Your mortgage debt stays the same while your property appreciates in value. As a result, you benefit from the full property appreciation, and it goes straight to your home equity. A healthy and expanding real estate market will passively increase your equity and wealth.
However, it is worth clarifying that many down payment assistance programs (DPAPs) use a shared equity mortgage. If you have a shared equity mortgage (which isn't common), some appreciation is shared with your mortgage lender.
Another way to increase the value of your home is through renovations. If you add an extra room to your home, increase the livable space by converting a garage into living space or change the paint and flooring of your property, then its value could rise.
Continue making mortgage payments
This one will take the longest to impact your home equity. This is because, in the first few years of paying off your mortgage, most of your payment is only paying off your loan's interest. As a result, they don’t significantly affect the bank's ownership of your property - otherwise known as the principal.
However, as you pay off the interest, more of your monthly mortgage payments will go towards paying off your principal balance. At this point, each payment will affect your home equity. You will see significant increases in the equity you own each year. Some homeowners prefer to make accelerated mortgage payments to pay off their mortgage and build home equity faster.
- Principal
- Interest
How to use Home Equity
Now that you know how to build home equity, let's talk about how you can use it. Typical uses include; retirement income, access to cash. Continue reading to learn about the best mortgage products for each objective and where to get them.
Retirement Income
Retirees can spend their golden years using their home equity to finance retirement. There are two main options; downsizing their home or using a reverse mortgage to stay in the same house.
- Downsizing: This is the traditional approach to retirement. Many retirees sell property with an experienced real estate agent then buy a cheaper home. From there, they can use the cash received from selling to help fund retirement. However, you may not want to sell your home, and if you do, then you'll have to pay capital gains tax if it's not your primary residence.
- Reverse Mortgage: A reverse mortgage allows retirees to continue living in their homes and receive a monthly payment to help fund retirement. With each payment you receive, the bank increases its ownership of the house. Eventually, when you sell the home, the bank will collect the amount of money owed. Additionally, the interest rates on reverse mortgages tend to be favourable.
Access to Cash
Homeowners in need of quick cash have many options to borrow against their equity. There are multiple reasons to borrow your home equity for cash, including; starting a business, home renovations, consolidating your debt, buying a cottage, paying your child's tuition, and many more. There are multiple products available with slight nuances, and this section will help you differentiate them to decide the best ones for your situation.
- Home equity line of credit: A HELOC is the most popular way to borrow from your home equity due to its flexibility. It is a pay-as-you-go option that allows you only to pay for the money you borrow. If you do not withdraw from the account, then you don't have to pay anything. HELOC interest rates tend to be higher than a typical mortgage, although many lenders provide interest-only periods.
- Cash-out refinance: Cash-out refinances are a great option for debt consolidation or investors. This option lets you borrow a large lump sum of money at a lower interest rate than a HELOC. However, unlike a HELOC, there is less flexibility because you receive a large sum of money and immediately need to pay interest. Additionally, you will need to change mortgages, so there may be a penalty for switching before your term ends.
- Second mortgage: Unlike a cash-out refinance, a second mortgage will allow you to keep the same primary mortgage. As a result, there is no risk your primary mortgage interest rate will increase, and you won't need to pay any penalties for ending your primary mortgage early. You will receive a lump sum of money at a slightly higher interest rate than a conventional mortgage.
| Loan Type | Maximum Total LTV | Interest Rates | Access to Money |
|---|---|---|---|
| Cash-out Refinance | 80% | Fixed or Variable. Typically lowest interest rates. | One bulk sum delivered to your bank account. |
| Second Mortgage | 80% Total | Fixed or Variable. Typically higher than a primary mortgage. | One bulk sum delivered to your bank account. |
| HELOC | 65-80% Total | Variable. Changes with the prime rate. | Pay as you borrow. |
| Reverse Mortgage | 55% Total | Fixed or Variable. Typically higher than a primary mortgage. | Either monthly installments or one lump sum. |
Taxes on Home Equity
Currently, in Canada, there is no capital gains tax for primary residences. This means any increase to your home equity will not be taxed as long as the property was your primary residence during its whole ownership tenure. However, as of fall 2021, the Canadian government has discussed introducing a home equity tax to homeowners.
This new home equity tax - called the "anti-flipping tax" will require primary residence owners to pay capital gains if they sell their property within one year of buying it.
Secondary residence and investment property owners must pay capital gains tax upon selling their property. As a result, many real estate investors prefer to cash out refinance their existing property and contribute the money to a downpayment on another rental property.
Secondary residence owners typically sell their primary residence first and then spend a few years in the secondary home until it qualifies as a primary residence. After qualifying the property as a primary residence, they typically sell it to take advantage of the tax exemption mentioned above.
The Bottom Line
In conclusion, home equity is the value of your home minus any debt you owe that is directly tied to your home. Homeowners in need of quick cash have many options to borrow against their equity, detailed throughout this article, including a home equity line of credit or second mortgage.
Frequently Asked Questions
What is home equity?
Home equity is the value of your home minus any debt you owe that's directly tied to your home. You can think of home equity as the portion of your home that you own as you pay off your mortgage.
What are home equity loans?
A home equity loan is secured by your home equity. You borrow money from your home and receive it in cash. They are a great way to turn illiquid assets (your home) into something liquid (cash). Additionally, they tend to have low-interest rates.
Am I eligible for a home equity loan?
To be eligible for a home equity loan, you must own more than 20% of your home. Additionally, you must have a good credit score to get the best interest rates. A HELOC is typically the most accessible home equity loan to get.
How much money can I borrow from my home?
In Canada, you can not borrow more than 65-80% of your total home value. For example, imagine you have a $100,000 home with $50,000 of debt tied to the property. Given an 80% maximum loan to value (LTV), you would be able to borrow up to a total of $80,000 from your property. This means you can borrow an additional $30,000 (80,000-50,000) from your home equity.
How much does it cost to receive a home equity loan?
There are multiple fees to keep an eye out for when receiving a home equity loan. Initially, there are origination fees which are upfront costs that include general administrative expenses such as an appraisal and legal fees. These fees tend to cost between $2,000-$5,000.
You may also pay a penalty for refinancing your mortgage before its term has ended. However, you can avoid these fees with a HELOC or second mortgage. You can use a mortgage penalty calculator to find this.
Finally, you must also keep the interest rate in mind. If you receive a cash-out refinance at a higher interest rate than your previous mortgage, you will end up paying more in interest over your loan.
What are the best renovations to increase my home equity?
Some great ways to increase the value of your home include renovating your bathrooms/ kitchen, installing new windows or a roof, and finishing your basement. However, these are more expensive projects that may require a home renovation loan.
If you are looking for smaller projects, then some items that have a significant impact on your home value include:
- Installing new lights
- Updating the curb appeal
- A fresh coat of paint
- Installing a new water heater