What is Home Equity and Why is It Important?

If you’re a new or recent homeowner, you might have any number things on your plate, like managing the upkeep of your property or paying off your mortgage. However, the one thing all homeowners could benefit from adding to that list is keeping track of their home equity. Whether you realize it or not, home equity is one of the most important aspects of owning property. But what is equity and how does it affect you?

Defining equity

Equity is a financial term referring to the cash value of an economic item, or an asset, after the costs of ownership are accounted for. With regards to your home or property, this would just be its current estimated value subtracted by the remainder of your outstanding mortgage. Depending on the circumstances, equity can be positive or negative. Positive equity is when the value of your home increases or “appreciates” above what you owe on your mortgage, while negative equity occurs if your home’s value decreases or “depreciates” below what you owe on your mortgage.

Even though equity refers to cash value, there are important points to keep in mind. First, equity is not static because there are a lot of fluctuating factors influencing property values, like your neighborhood’s local amenities or the status of the overall housing market. The second point is that even though equity refers to cash value, you can’t treat it like money in a bank unless certain conditions are met. Selling your home, for example, will allow you to obtain your equity in the form of cash. Similarly certain types of loans, like a Home Equity Line of Credit (HELOC), will allow you to borrow money directly from your property’s equity.

Why equity is important

There are many reasons why equity is important, but some of the biggest reasons include:

1. Selling. Unfortunately, after the housing market bubble of last decade, a lot of Americans had negative equity and found themselves carrying underwater mortgages — meaning they had negative equity. The main reason negative equity is bad is because it means you owe more on your home than what it’s worth. If you plan on selling the house while it’s underwater, you’ll basically be throwing money away. This is exactly why underwater homeowners feel so trapped, losing value in their home can make them feel obligated to stay until it appreciates again. In some cases, this could take an entire lifetime.

2. Defaulting. If you default on certain types of loan payments, the lender wants the ability to recoup their money. They often secure debt by having you give up something as collateral if you fail to pay; this is essentially what foreclosure is. The problem for underwater homeowners is that their home is insufficient as collateral, as their current mortgage balance exceeds their property’s value. Even if they were to allow their lender repossess their home after missed payments, in many cases, they would still owe money. Negative equity also affects any other debt involving your house as collateral, like the HELOC loans mentioned above, which is important to keep in mind if you’ve used your home as collateral for more than one loan.

3. Refinancing. In most cases, lenders don’t like to refinance underwater mortgages because it’s a huge risk. That’s where programs like the Home Affordable Refinance Program (HARP), which is ending this year, have changed things, as they give homeowners who’ve seen a drop in their home value refinance with better mortgage terms. Still, it’s the lender who chooses whether or not to approve the loan. Aside from making timely payments on their current mortgage and seeking a willing HARP lender, underwater homeowners don’t have many options that guarantee them refinancing.

4. Renovating. What your home looks like is your business, except when it’s for sale. Generally renovations and upkeep have positive effects on equity, but there are instances where modifications can actually hurt your home’s value. For example, while painting all of your walls hot pink can be undone, renovations that will require intensive labor to reverse, such as removing or downsizing a closet, can be seen as a negative. Unless you know your preferences are universal, it’s best not to go overboard with any exotic and irreversible home makeovers. The biggest changes in equity, though, come from modifications that restructure the home, like converting any existing rooms into different types of spaces. Getting rid of a bedroom, turning a garage into an office or merging rooms together might reduce the market appeal and price of your home. That said, simply adding rooms, without converting others, generally has positive effects on equity.

Follow our personal finance blog for more tips, and if you’re in the market for a mortgage, make sure to take a look at our mortgage page, where you’ll find plenty of helpful resources, including a mortgage calculator and a rent vs. buy tool.