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As you make your mortgage payments each month, you build equity in your home. The term “equity” refers to the difference between the value of your home and what you owe on it. For example, someone whose home has a fair market value of $200,000 and whose mortgage balance is $180,000 has $20,000 of equity.
In the early stages of the mortgage term each monthly payment is applied mostly to interest. But over time, a larger and larger portion of each payment goes toward the principal. So the rate at which you accumulate equity in your home increases over time.
Your equity can also grow through home price appreciation. As your property’s market value increases, so does your equity. Most homeowners will gain more equity this way than through paying down their principal, especially early in the mortgage term.
Accessing Your Growing Wealth
As your equity grows, you may be able to borrow against it to pay for home improvements, college tuition, a new car, or a host of other expenses. Using your home equity can be a smart way to borrow because the interest you pay may be tax-deductible, unlike credit cards and other loans. Make sure you consult your tax advisor about the deductibility of interest.
Home equity is usually accessed with either a cash-out refinance or a home equity loan or line of credit.
- Cash-out refinancing involves getting a new mortgage for an amount greater than your current mortgage balance, and taking the difference in cash. That difference is deducted from your equity. What percentage of your equity you can borrow against depends on your financial profile and on the loan program you choose.
- Home equity loans and lines of credit involve getting a second loan on top of your original mortgage, taken out against a portion of the equity in your home. Like a cash-out refinance, a home equity loan gives you a single lump sum. A home equity line of credit, on the other hand, establishes an account that you can draw from as needed up to a specified maximum amount. The advantage of a home equity line of credit is that instead of paying interest on the total amount of the line, you pay interest only on what you actually withdraw.