What is Equity?

One question a lot of first-time homebuyers ask is: What is Equity? Here is what it means and how it applies to homeownership.

Equity is the amount of ownership of an asset purchased through a secure loan. Think of buying a house or a car. Unless you buy one outright in cash (kudos on being an awesome saver), you will have a certain amount of equity in what you buy based on your down payment.

As you know, when you take out a loan on a house, the bank cuts you a check that you use to purchase the home. From that point, the bank owns the house except for what you put down as a down payment. The down payment is your current equity on the house. The bank owns the rest of the value of the home. From that point, you pay the bank every month until the house is paid off. If your payments are $2,345.67, that means that each month you are buying $2,345.67 worth of equity in your home.

If you do not make payments, your house will go into foreclosure. At that point, the bank will seize the property from you, because it still owns the house. The bank will then try to sell the property for the remaining balance of the loan. It can’t sell it for more because it doesn’t own what you have already paid for it (i.e. your equity).

What is a home equity line of credit?

This is another common question that deals with equity. A home equity line of credit (HELOC) is when a homeowner takes out a loan on their equity in the home. They cannot take out more money than they own of the total value of the house, but can take out a sum up to the total equity amount. It works like a credit card, where you have a limit on how much you can spend, and it must be repaid in a given time frame plus interest. The credit limit is determined by the lender and the interest rate can change based on the market. Consult your lender or financial professional for more information. This is different from a home equity loan, which is explained next.

What is a home equity loan?

A home equity loan is when the borrower uses the equity of their home as the collateral on the loan. The amount of money (given in a lump sum) is determined by the property’s value, which is determined by an appraiser. A home equity loan creates a lien on the property, which reduces the home equity because the lender is now owed more money by the borrower. When the home equity loan is repaid in full, the lien goes away, and you can return to making payments on the original loan to rebuild equity in the property. Once again, consult your lender or financial professional for more information.

Up next: What is Escrow?