How Homeowners Build Equity
How Homeowners Build Equity
Building equity is one of the main benefits of home ownership. You don’t notice it while it’s happening, but at some point you’ve got a valuable asset that can be used for almost anything.
What is Equity?
Equity is the amount of your home that you actually own. If you borrowed money to buy your home, you can calculate your equity by subtracting your loan balance from the value of your home. If you end up with a negative number, you’ve got negative equity – the home is worth less than you owe on it.
Example: your home is worth $250,000 and you owe $100,000 on your mortgage. $250,000 minus $100,000 equals $150,000 of equity in your home. This is the value you can do something with if you sold the home.
How to Build Equity
The more equity you have, the better. There are two ways to build equity:
- The property value increases
- The amount of debt decreases
You can take an active or passive approach to building equity, depending on your goals, your resources, and your luck.
Increase the Property Value
Your home’s market value is an important element in your equity calculation. If that goes up, you instantly have more equity. So how does your home rise in value?
Rising prices in your market: if you’re lucky, home values in your market might simply rise over time, without any effort on your part. This is most likely to happen in attractive neighborhoods and growing towns.
Home improvement: you can also invest in your home to increase its value.
Updating kitchens and bathrooms, improving landscaping, and making the home more energy-efficient can all pay off (but there’s an up-front cost, and you need to make sure you can more than recoup those costs). If you’re doing improvements mainly to build equity, pick projects with the highest return on investment (ROI).
Upkeep: routine maintenance is boring, but a home that’s falling apart is not worth much to anybody. You can actually see your home equity decrease if you fail to address issues like leaks and deteriorating roofing.
Decreasing the Debt
Monthly payments: with most home loans, you pay down your loan balance a little bit each month. A basic amortization table can show you the process in action. The longer you have your loan, the more principal you pay (more of each payment goes towards equity, and less of each payment is lost to interest charges). It’s actually pretty easy if you just keep making payments – and you build momentum (with larger and larger principal payments) without even trying.
But you might want to accelerate the process and build equity more quickly. There are several ways to do that.
Shorter term: shorter term loans cause you to pay down debt and build up equity more quickly than long term loans. For example, a 15-year mortgage would be better than a 30-year mortgage. As a bonus, those shorter term loans often come with lower interest rates – that, combined with the fact that you’re paying interest for fewer years, means you’ll actually spend less on interest over the life of your loan.
Extra payments: even if you have a 30 year mortgage, you can speed things up by paying extra. Each extra dollar you pay (above and beyond your required payment) reduces your debt and goes towards your equity – just make sure your lender applies those payments to the principal. There’s nothing stopping you from setting up a 15 year repayment schedule (see the link to the amortization table above) and making those payments on your 30 year loan. If things change at some point and you can’t afford to do that any more, you’ve got the flexibility to go back to the smaller 30-year payment. If that’s too complicated, just send an extra payment from time to time.
Leave it alone: second mortgages and refinancing can interfere with debt reduction. Obviously, if you can save a bundle by refinancing, go ahead and do it.
But remember that with most loans, you pay mostly interest in the early years of your loan – so every time you start over, you delay (or at least slow down) your equity building. Borrowing against your home with a second mortgage (or home equity line of credit) clearly increases your debt and reduces your equity.
Sometimes people refer to a mortgage payment as "forced savings." You might not think you're saving any money by making payments each month, but you are building up the value of an asset (like you would build up the value of a savings account by making regular deposits). With a home, the asset isn't cash in a savings account - it's equity in your home.
What can you do with Equity?
You might wonder what you get out of all that equity. The short answer is that it's an asset that you can trade for other assets.
- If you sell your house, you'll get cash for your equity
- If you're buying another house, you can use that money (or the equity) to help fund the purchase of your new house (and therefore you'll borrow less)
- If you ever need cash, you can borrow against the equity in your home with a second mortgage (also known as a "home equity loan")