When you take out a mortgage to buy a home, it might seem like you’ve just taken on a huge amount of debt. While this is partly true, you also need to consider the value of your new home. Because your mortgage debt roughly equals your home’s value, your overall wealth will not have changed by much.
To help measure the actual financial wealth that homeowners hold in their property, there’s a useful concept called home equity. But what is home equity, and what’s it useful for? Regardless of how you use your home equity, it’s an important concept for homeowners to understand.
What is home equity?
Your home equity is the amount of personal equity, or wealth, that you hold in your home. You can calculate home equity by taking the current market value of your home, then subtracting any loans you have against the home, an outstanding mortgage for example. If you don’t have any loans against your home, then your home equity is equal to the full market value of your home.
Home equity is a useful indicator of the distribution of your wealth, but it’s most often used when it comes to borrowing money. Home equity is an asset that you can borrow against by using a home equity loan, like a second mortgage or a home equity line of credit (HELOC). We’ve covered home equity loans in more detail below.
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How to calculate home equity (example calculation)
Let’s say your home has a market value of $500,000. When you first purchase your home, let’s assume you had a $100,000 down payment, so your mortgage amount was $400,000. While there may be other costs associated with opening a mortgage (land transfer taxes, GST/HST, mortgage default insurance, etc), we’ll ignore them for simplicity. Your home equity would be calculated as:
$500,000 (home value) – $400,000 (outstanding mortgage) = $100,000 (home equity)
Now let’s jump ahead a decade or so, and assume that you’ve reduced your outstanding mortgage amount by $100,000, to $300,000. Let’s also assume that the market has been good to you and that your home has appreciated in value by $100,000. Your home equity calculation now looks like this:
$600,000 (home value) – $300,000 (outstanding mortgage) = $300,000 (home equity)
Because your home equity changes as your home changes in value, your home equity is not strictly a measure of how much you’ve paid off your mortgage. While paying off your mortgage directly increases your home equity, changes to your home’s value means that your home equity will change with the real estate market. Of course, this also means that your home equity can go down over time, even if you continue to pay off your mortgage.
What is a home equity loan?
One of the main ways home equity is used in Canada is as an asset for a home equity loan. A home equity loan is any kind of loan where you borrow money using your home equity as collateral. Home equity loans are often used for large, one-time purchases like university tuition fees, home renovations, or medical bills. Unlike an unsecured loan, home equity loans result in the lender being issued a lien on your home. This means that if you cannot pay your debts, your lender will be able to claim a portion of the sale of your home to cover the outstanding amount.
The maximum size of a home equity loan is generally set as a percentage of your home’s appraised value, 80% for example. The exact percentage will vary depending on the type of home equity loan you’re using. Below are the four common types of home equity loan in Canada.
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1. Second mortgages
Second mortgages could be considered the ‘standard’ home equity loan, and are exactly what they sound like. In addition to your primary mortgage, a second mortgage lets you borrow a portion of your home equity as cash. Both mortgages cannot exceed 80% of your home’s total value.
Second mortgages have much higher rates than regular mortgages. This is because second mortgage lenders are considered lower priority than primary lenders in the case of a default. As a result, providers of second mortgages are exposed to higher risk.
2. Home Equity Line of Credit (HELOC)
A home equity line of credit, or HELOC, is a special type of home equity loan that is bundled with your primary mortgage. Rather than giving you a cash lump-sump, your lender will set up an account that you can withdraw from over the course of your mortgage term. The amount available to withdraw from that account is set at the beginning of your term, but your total credit available cannot be more than 65% – 80% of your home’s total value.
A HELOC is a revolving line of credit which, once you withdraw funds from it, requires monthly repayments of the interest accrued. In some ways, using a HELOC is like using a credit card, but you withdraw the funds as cash, rather than using it for purchases. However, because a HELOC is a secured loan, the rates are much lower than credit card interest rates.
3. Refinancing to access your home equity
Refinancing your mortgage is another way you can access your home equity. When you refinance your mortgage, you have the option of borrowing more money from your lender. The maximum amount you’re able to borrow is 80% of the total value of your home. Refinancing often carries other fees and can result in a higher mortgage rate than you were charged on your old mortgage. However, the benefit of refinancing is that you don’t have to take out a second loan, like some other types of home equity loans.
4. Reverse mortgages
Reverse mortgages are a niche product, but they are also a kind of home equity loan. Reverse mortgages are exclusively used by older Canadians, generally as a way to fund their retirement when they don’t have enough cash or aren’t receiving a large enough pension to live comfortably
With a reverse mortgage, people aged 55 and over can borrow up to 55% of their total home value, either in installments or as a lump sum. There are no repayments required on a reverse mortgage until the loan comes due, which happens when the borrower sells or moves out of the home, or dies. The proceeds of the sale of the home are usually used to repay the loan. Like all home equity loans, reverse mortgages accrue interest over time, at a rate that is generally higher than both regular mortgages and HELOCs.
The bottom line
Home equity on its own is just an indicator of where you hold your wealth. It’s an important indicator, as it makes clear the sometimes hidden value that’s trapped inside your home. However, in those moments where you need to borrow cash to fund a big purchase, your home equity is one of the most important assets you have. Understanding what home equity is and what options you have to borrow against it are essential factors in modern financial planning.
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