Understanding Home Equity and When to Refinance

Home equity is the portion of your home's value that you own outright — the market value minus what you still owe on your mortgage. Building equity is one of the primary financial benefits of homeownership, and understanding how to use it wisely is an important part of your overall financial planning.

You build equity in two ways: through principal paydown as you make monthly mortgage payments, and through appreciation as property values in your area increase. Making even small additional principal payments each month can dramatically accelerate your equity build and shorten your loan term significantly.

A cash-out refinance allows you to convert some of your equity into cash, which many homeowners use for home improvements, debt consolidation, or major expenses. The key is to be thoughtful about what you're using that equity for — funding appreciating assets or necessary home improvements makes more financial sense than funding vacations or depreciating purchases.

Refinancing to lower your interest rate can save significant money if rates have dropped substantially since you bought. The general guideline is that refinancing makes sense if you can lower your rate by at least three-quarters of a percent and plan to stay in the home long enough to recoup the closing costs through your monthly savings — typically two to three years. Calculate your break-even point carefully before committing.