What Does Equity Mean in Real Estate?
Tips for Building Equity That Can Increase Your Net Worth
Equity is the difference between the market value of your home and the amount you owe to the lender on the mortgage. If you were to sell the house, the equity would be the money you would receive after you paid off the mortgage. It's the difference between market value and your mortgage balance. It's a nuanced number.
Here is an overly simplified example: The fair market value of your home is $200,000 and you owe $150,000 on the mortgage.
Your equity is $50,000.
Explanation of Net Equity
Net equity is different from gross equity. Net equity is the gross equity less the costs of selling the home. These costs may include the commission for the realtor, unpaid property taxes, and items in the closing costs you did not pass on to the home buyer.
For example: Your home sells for $200,000 and your mortgage on the home was $150,000. Your equity is $50,000. However, you may owe a commission of $12,000 to your Realtor. Your other closing costs such as escrow fees, title charges and tax prorations, etc., could add another $3,000 in seller-paid costs. Your net equity is then $35,000. Net equity is the amount you would pocket at the end of the sale.
How is Home Equity Built?
Homeowners can build home equity in a variety of ways:
- Down payment: The money you put into the home that reduces the initial mortgage. For example, a 20 percent down payment on a home valued at $100,000 is $20,000. You would start with an equity of $20,000 and avoid the need to pay mortgage insurance. Your mortgage would be the remaining $80,000 to start.
- Mortgage payments: With each mortgage payment, you build equity by paying on the principal, while also paying the interest on the loan and any insurance and tax payments you include in the total. Your equity increases as you make mortgage payments.
Extra payment on mortgage principal: You can make extra payments on your mortgage to apply to the principal. This increases your equity.
Home improvements: If you make home improvements that raise the fair market value of your home, this increases your equity. For example, you spend $50,000 on a kitchen remodel that increases the market value by $30,000. Now you have raised your equity by $30,000, assuming you didn't take out a home equity loan to pay for it. This is a hypothetical increase in equity. You will only know how much it increased the value of your home once you sell.
Market value appreciation: The fair market value of your home may rise because similar houses in your area are now selling for more money. A lender may be willing to refinance your mortgage at the higher value. For example, you bought your home for $100,000 with a 20 percent down payment. Over the past two years, similar homes are selling for $120,000. Your equity in the home has increased by $20,000 due to this rise. This is also hypothetical. You must sell the home to realize this equity.
How is Home Equity Reduced?
You can also see your home equity fall. We don't need to look back very far to see how that could happen, take the years of 2006 to 2011 in just about any real estate market in the country, and values fell. When housing values fall, equity falls right along with it.
Here are a few ways you can reduce your equity:
- Increase the principal loans on the home: If you refinance your mortgage, take out a second mortgage or home equity loan, you may decrease your equity.
- Fall in market value: If homes are selling for less in your area, your equity also falls. This is what happens when you are underwater on your mortgage. For example, you bought a home for $200,000 with 20 percent equity, equaling $40,000. But the real estate market fell, and now similar homes are selling for $150,000. Your equity has fallen by $50,000, and you no longer have any equity in your home. If you sold for $150,000, you would have to pay the mortgage lender $10,000 to make up the difference.
- Your home burns down, and you don't have enough insurance to pay for your loss.
- Deferred maintenance. If you don't keep making repairs to your home with things deteriorate or stop working correctly, the cost to cure will eat into your equity position.
The bottom line is that you only know the equity in your home at the end of the sale. Until that point, it is all hypothetical. If you can negotiate a better selling price from the buyer, you will increase the equity you get paid out. Conversely, if you don't pay for repairs as requested by the buyer or give the buyer a credit for closing costs, your equity will rise.