A basic guide to home equity for first-time buyers

If you’re starting to think about buying your first place but don’t know the difference between home equity and Homer Simpson, don’t worry. You’re not alone.

The home-buying industry works differently from a lot of the rest of the economy, and comes with its own vocabulary, standards, and expectations. Many of us don’t even realize we have a home-buying knowledge gap until we’re sitting across from a bank officer, wondering if the mortgage points they keep talking about have something to do with correct answers to trivia questions. (Sadly, points are a lot less fun than that.)

Even well-meaning financial experts with teaching experience (ahem) can forget the importance of defining concepts. The term home equity is a prime example of the kind of important term that gets bandied about as if everyone knows exactly what it is. And that can make it intimidating to ask. But home equity is too significant a part of ownership for you to rely on a vague understanding and general vibes.

Here’s everything you need to know about what home equity is, how you can get some–and why exactly it makes financial professionals flush with pleasure.

Mortgage basics

To understand home equity, you need to start with mortgage lending.

Homes in the U.S. have a median sales price of $420,000-plus, which is an amount of money you’re unlikely to have set aside in checking or hanging out in the pocket of the coat you haven’t worn since last winter.

This is why pretty much every homebuyer has to take out a mortgage loan to purchase a house. With a mortgage loan, the buyer will make a down payment to the lender, and the lender finances the rest of the purchase. The buyer will then make monthly payments of principal (the original amount borrowed) plus interest to the lender until the mortgage is paid, which typically takes 30 years.

As of 2024, first time homebuyers financed a median of 91% of their home purchase price, meaning they made a down payment of 8%. For a $420,000 home, that would mean a down payment of $33,600 and a mortgage loan for $386,400.

Property values

The next component of equity is the value of the home, which is a more amorphous designation than most things you buy. There’s no price tag on a home, since a house is worth what a buyer is willing to pay.

Homes are also unlike most other purchases because it’s an appreciating asset. In other words, homes are usually worth more money as time goes on, even though most things you can buy lose value.

Since property values have traditionally had a consistent upward trajectory (with some very notable exceptions), most homeowners expect their home’s value to increase significantly over the life of their mortgage.

(This, by the way, is why your dad is obsessed with property values and gets so upset at the neighbor with the permanent pile of yard tires. Buyers are less likely to want to pay top dollar for a house next door to the Springfield Tire Yard.)

A simple definition

Home equity is the difference between how much your property is worth and how much you owe on your mortgage. It is the portion of your home that you own free and clear.

For example, if your house is worth $350,000 and you owe $300,000 on your mortgage, your home equity is $50,000, or approximately 14.3% equity. ($50,000 ÷ $350,000 = 0.14285).

Generally, you are not considered to have equity in your home until you reach 20% equity. This is why 20% is the traditional down payment amount. Making a 20% down payment means you immediately have home equity.

How to build equity

There are two ways to build home equity, and most people will do both at the same time:

• Mortgage payments: Each monthly mortgage payment includes a portion that goes toward paying off your principal. Every month, you build a little more equity in your house. You can build equity more quickly by sending additional principal payments when you can.
• Property appreciation: For most homebuyers, the property value will increase over time, meaning you have more equity simply by staying in your home for several years. While market downturns or other issues could lower your property value, you will typically benefit from appreciation over time.

Why home equity matters

If you’re wondering why your uncle is always nattering about how you’re not building any equity by renting, there’s more to home equity than just owning more than you owe. Home equity offers real and tangible benefits to homeowners. Specifically, building up equity in your house does the following:

• Increases your net worth: A higher net worth offers more financial flexibility because it’s easier to borrow money at competitive interest rates.
• Nets you higher proceeds when you sell your home: If you sell your home before paying off your mortgage, your equity is the amount of money you can cash out of the sale.
• Opens up inexpensive loan options: If you have equity in your home, you can qualify for a home equity loan or home equity line of credit. These loan options are secured by  your home and allow you to access your equity with favorable rates and terms. Home equity loans and lines of credit are among the cheapest borrowing options available.
• Allows you to access cash with a refinancing loan: A cash-out refinance lets you replace your existing mortgage with a larger loan and take the difference in cash. This is only possible if you have built equity in your home.

The fine print

Home equity means your humble abode can also be a potential source of money if you need it. But thinking of equity as a personal piggy bank can lead to trouble.

That’s because accessing your equity is basically the same as turning your assets back into debt, which reduces your net worth. Part of the way lenders try to protect homeowners is by limiting the amount of equity you are allowed to access via home equity loans or cash-out refinancing. You will generally have to keep at least 15% to 20% equity in your residence.

The other caveat about equity is that property values do not always go up. If the housing market takes a header, it’s possible to quickly lose equity in your home. Other than waiting for the market to recover, there is no other way to recoup lost equity after an event like that.

America dreams of equity

A cute suburban house with a white-picket fence wasn’t just a place for our grandparents to wear pearls while vacuuming. It also allowed them to build wealth through the power of home equity.

To calculate your equity, subtract your remaining mortgage balance from the current value of your house. Divide the number you come up with by the mortgage balance to get your equity, which represents the percentage of the home you own. Lenders generally don’t consider you to have equity until you reach 20% equity.

Equity in your home gives you more options for borrowing, but tapping the equity in your home trades your assets for debt. Also, even though home values traditionally go up, there’s no guarantee that they always will. So tread carefully if you decide to access your home equity.

Even if home ownership is not yet on your radar, understanding home equity can help you make better decisions about your current finances.