What is home equity and how can I use it?

Home equity is the amount of your house that you own outright — or, simply put, the difference between your outstanding mortgage and your home's total value.

For most people, their home is their most valuable asset, so home equity is essential to your net worth and can help you achieve other financial goals.

Below, CNBC Select explains how home equity works, how you can use it, and what to consider before you do.

As you make mortgage payments, you reduce the balance of your home loan and build equity. If you make additional mortgage principal payments, you can build your equity quicker.

However, that's not the only way your home equity can increase.

Equity is based on the value of your house rather than just the percentage of the mortgage principal you've paid down. If your home value rises, so does your home equity.

For example, certain home improvements can raise your property's value. When you add an extra room for a home office or do a full kitchen remodel, you're not just shaping your home to fit your lifestyle. You're also potentially increasing its value and your equity.

Your home value can also increase without your participation at all if your home appreciates. Typically, property values go up over time. This, of course, isn't guaranteed and depends on your local market and the overall economy. Still, it can be beneficial to keep an eye on the home price data in your area to have an idea of where values are going.

To calculate your home equity, subtract your remaining mortgage balance from your home's current market value. Since home values fluctuate, figuring out how much your home is worth in today's market may require some work. If you're just curious and want a vague idea of what your home is worth, you can use an online home value estimator available on websites like Zillow or Redfin. But if you need a more accurate estimate, consider getting in touch with a local licensed appraiser.

Building equity helps you build wealth — but it can be useful for more than that. Having enough equity in your home can allow you to do the following:

Get rid of private mortgage insurance (PMI)

If you have a conventional mortgage and put less than 20% down, your lender requires you to pay private mortgage insurance. To clarify, this isn't homeowners insurance. It's not designed to protect you as a homeowner — it's there to protect the lender in case you default on your mortgage. Typically, it's included in your monthly mortgage payment, adding a few hundred dollars to it.

Needless to say, it's a pesky monthly charge many homeowners look forward to eliminating. Once you reach 20% equity in your home, you can get in touch with your lender and request to cancel your PMI. Most lenders also automatically do this for you when you reach 22% equity.

Refinance

Refinancing your mortgage can offer plenty of benefits, depending on the market conditions. For example, you can get a lower interest rate and monthly payment, or even shorten your payoff term. You usually need to have at least 20% in home equity to refinance.

Refinancing can also give you an opportunity to get rid of a mortgage insurance premium (MIP) — mortgage insurance you pay on an FHA loan. If you've made less than a 10% down payment, you're on the hook for paying MIP for the life of the loan unless you reach 20% equity and refinance into a conventional loan.

CNBC Select ranked the best refinance lenders and picked SoFi as the best for saving money and Ally Bank for no lender fees.

Borrow against your home equity

Having money tied up in home equity doesn't mean you can't access it. You have a few options to borrow against your equity:

• Cash-out refinancing, which replaces your current mortgage loan with a larger one and gives you the difference in cash. The more equity you have, the more cash you can get. To qualify, you'll typically need 20% equity in your home. CNBC Select recommends Rocket Mortgage for cash-out refinancing as it may allow you to cash out your full equity if needed.

• Home equity line of credit (HELOC), which provides you with a line of credit secured by your home. The amount of cash you can qualify for depends on how much equity you have. A HELOC has what's called a draw period, usually between five and 10 years, when you can borrow the money and pay it back to borrow again — similar to a credit card. After that, the repayment period begins, during which you'll make monthly principal and interest payments on the remaining balance. This period can last between 10 and 20 years.
• Home equity loan, which also allows you to borrow against your equity, but in this case, you get a lump sum you pay back in installments over a specified period. You can think of it as a large personal loan secured by your home. You pay it back on top of making your primary mortgage payments, which is why a home equity loan is often called a second mortgage.

There are multiple situations where borrowing from your home equity may be justified. If you're beginning to feel house-poor and your debt seems to keep growing, tapping into your equity may be an option to help you pay it off. Or you can use it for home improvement projects — which, in turn, can increase your home's value. Some people also use their home equity to put money down on an investment property or to start a business.

No matter how you plan to use your home equity, you need to approach borrowing against it with a sense of responsibility. After all, when your home is collateral, you risk losing it if you default. Make sure you're clear about the costs of borrowing against your equity and shop around for lenders to find the best deal.

Consider other options as well. They might not come with the same benefits, such as low interest rates or tax breaks, but you also won't be putting your home on the line. For instance, if you need to climb out of debt, look into balance transfer credit cards and debt consolidation loans. If you're trying to fund a home remodeling project, maybe you can find a good card for home renovation and earn rewards.

Whatever you decide, make sure you've thought things through and aren't borrowing against your home equity on a whim.

Your home equity is one of the most valuable assets you have, and it can increase over time. Before you decide to tap into your equity, make sure it's a responsible step to take in your circumstances — you don't want to put your primary residence at risk if you misuse the funds. Plus, you might find other financial tools that can help you meet your goals.

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