Can you explain what home equity is, please?

Highlights

• Your down payment is your first step toward your home equity.
• You can take out equity through home equity loans and lines of credit.
• There are loan programs even if you have negative home equity.

Thank you for your question about home equity.

Your home is one (if not the single) most valuable asset you own. Everyone needs a place to live and you can choose between renting and buying. Most Americans prefer to purchase a home, take a mortgage to finance the purchase and gradually build up their equity in the home.

Equity means the amount of money you have invested in the property after paying all the mortgages and home loans. A lender refers to the equity in terms of the LTV (Loan to Value ratio). That means if you have a house worth $350,000, a mortgage for $245,000, your LTV is 70%, and your equity position is 30%. You would have $105,000 of equity in the house (not counting selling costs and taxes). If the price of your property goes up, then you have a lower LTV and a higher amount of equity in your house. If the price goes down (we are all familiar with that scenario), then your equity position decreases and can become negative.

Since your house is such an important part of your investment portfolio, and a necessity, it is important to understand how home equity affects your life. Learn about home equity as it affects you in different cycles of your home ownership process, as follows:

• Purchasing a House
• Refinancing a House
• Taking Cash out of your House
• Dealing with Negative Equity

Home Equity: Purchasing Your Home

Your down payment is the first equity you put in your home. The amount of down payment is an important factor in determining the amount of loan you receive and the terms of the loan including the interest rate. Here are some general rules regarding down payment and loan sums:

• Conventional loans . Lenders offer up to 80% LTV, which means your down payment has to be at least 20% of the purchase price.
• Conventional loans with Mortgage Insurance. Lenders offer up to 95% financing if you pay for mortgage insurance, which means that you need to make a small initial investment of 5% of the price of the house.
• FHA loans . FHA loans require only a 3.5% down payment, but require Mortgage Insurance Premiums, both upfront and annual. FHA loans not only require a small equity position, but also have less stringent credit requirements.
• VA loans . If you have a VA eligibility card, then you can take out a VA loan with no down payment. That means you can receive 100% financing with no equity stake in the house. The VA loan also does not require mortgage insurance.
• Note. Lenders will take the lower value between your purchase price and the appraisal report, which means in certain cases (such as a foreclosed or short sale property) your equity position, based on your market value, will be higher than that based on your down payment.

The second step in purchasing a home is deciding the length of the mortgage. Mortgage loans are generally offered up to 30-years, although you can take the loan for other periods including a 10-yea, 15 year or even 40-year period. The longer the period you take, the longer it takes you to build up equity in your house.

The table below shows how much equity you will build in 7 years for a $350,000 house and $280,000 initial loan — 80% LTV and $70,000 equity position. The example assumes that there is no change in the value of your house: