Understanding Home Equity

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One of the great benefits of owning a home is that as you pay off your mortgage loan you build up equity.

What exactly is home equity?

Simply put, home equity is the amount of your home you own. In other words, it is the difference between how much your home is currently worth and how much you owe on your mortgage loan.

It is important to know your equity, because you can use your home's equity as a financial tool. You can take out home equity loans or home equity lines of credit to help pay for your children's college education, fund the addition of a new master bedroom or pay down high-interest-rate credit card debt.

However, until you understand exactly how much equity you have, you will not be able to use this financial tool effectively.

Determining your home equity

It is relatively easy to determine how much equity you have in your home. Though to get an accurate figure, you'll need to enlist the services of a real estate appraiser. This professional will study your home, and surrounding homes, to determine what your residence is worth in the current market.

This is not free. Depending on the size of your home, you can expect to pay an appraiser about $400 to come up with a market value.

Once you have this market value -- you can also estimate your home's current market value yourself by analyzing recent home sales in your neighborhood -- you can calculate the amount of equity you have in your residence.

Say you owe $200,000 on your mortgage and your home is now worth $300,000. That is an easy one: Your home equity is $100,000.

If housing prices fall, it is possible to have negative equity, or to be 'upside down' on your mortgage. Say you owe $200,000 on your mortgage but because of falling home prices in your community your house is only worth $150,000. You now have a negative equity of $50,000.

Types of home equity debt

If you have positive equity, you can turn it into cash through a home equity loan or home equity line of credit.

If you take out a home equity loan, you'll receive a one-time lump sum of cash that you then pay back over a set amount of time, usually 10 or 15 years. This loan will come with a fixed interest rate, meaning that you'll make the same payment each month.

A home equity line of credit works more like a credit card. With a line of credit, you can borrow up to a certain amount of money for the term of the loan, a term set up by your lender. If you have a $50,000 home equity line of credit, you can borrow $10,000 to pay for a kitchen renovation. You'll then owe the $10,000 that you've borrowed. However, you'll still have $40,000 left on your line of credit. This means that you can borrow as much as $40,000 to pay for other expenses.

Keep in mind, though, that, like a credit card, you will not be able to borrow anything if you've maxed out your line of credit. Until you repay that $10,000 you borrowed, you'll only have access to $40,000.

Home equity debt is a useful financial tool. However, you do have to be careful. The collateral for home equity lines of credit or home equity loans is your home. If you miss payments or can't pay back the money you've borrowed, you could lose your home.