How Does Home Equity Work When Selling a Home?

Understanding Home Equity

Home equity is primarily calculated by subtracting your outstanding mortgage balance from your home’s current market value. For instance, if your home is valued at $400,000 and your remaining mortgage debt is $250,000, your equity would be $150,000. This calculation provides a straightforward snapshot of your ownership stake at any given moment.

Several factors can influence the growth or reduction of your home equity. Regularly making principal payments on your mortgage directly increases your equity by reducing the outstanding debt. Market appreciation, where the value of homes in your area rises, also contributes significantly to equity growth. Making substantial home improvements, such as renovating a kitchen or adding a bathroom, can increase your home’s market value and, consequently, your equity.

Conversely, home equity can decrease. A decline in local real estate market values will reduce your home’s worth and thus your equity. Taking out new loans against your home, such as a home equity line of credit (HELOC) or a second mortgage, will increase your total outstanding debt secured by the property, thereby lowering your available equity. These actions convert equity into cash or credit, reducing your ownership stake.

Realizing Equity During a Sale

When you sell your home, the process involves converting your accumulated home equity into cash proceeds. The starting point for this calculation is the agreed-upon sale price of your property. From this gross amount, several significant deductions are made before you receive your net equity.

The first major deduction is the payoff of your outstanding mortgage balance. The proceeds from the sale are used to fully satisfy this debt, clearing the lien on the property. Following this, various costs associated with the sale are subtracted from the remaining funds. These include real estate agent commissions, which commonly range from 5% to 6% of the sale price and are paid to both the seller’s and buyer’s agents.

Additional deductions come from closing costs, which can vary but often total between 2% and 5% of the sale price. These costs encompass a variety of fees, such as transfer taxes levied by local or state governments, title insurance premiums that protect against future claims on the property’s title, and escrow fees paid to the neutral third party managing the transaction. Attorney fees, if legal representation is used, are also part of these deductions.

Moreover, sellers might incur expenses for agreed-upon repair credits or concessions to the buyer, which are subtracted from the sale proceeds. After all these expenses—the mortgage payoff, real estate commissions, closing costs, and any seller concessions—are deducted from the gross sale price, the remaining amount represents the net proceeds from your home equity that you receive. This final figure is the tangible realization of your ownership stake.

Using Sale Proceeds

Once your home sale is complete and all associated costs and debts are settled, the net proceeds from your home equity are disbursed to you. A common use for these funds is as a down payment on a new home, allowing you to transition your equity from one property to another. These funds can significantly reduce the amount you need to borrow for your next mortgage, potentially leading to lower monthly payments or a more favorable loan-to-value ratio.

Alternatively, sellers may choose to use their proceeds to pay off other existing debts, such as credit card balances, auto loans, or student loans. This strategic use of funds can improve one’s overall financial health by reducing interest expenses and freeing up cash flow. The remaining funds can also be directed towards savings or investments, contributing to long-term financial goals.

It is important to consider the potential tax implications of selling your home, specifically regarding capital gains. For a primary residence, the Internal Revenue Service (IRS) offers a significant capital gains exclusion. Single filers can exclude up to $250,000 of profit from the sale, while married couples filing jointly can exclude up to $500,000. To qualify for this exclusion, you must have owned the home and used it as your primary residence for at least two of the five years leading up to the sale. Any profit exceeding these exclusion limits may be subject to capital gains tax, depending on your income bracket and how long you owned the property.