What is Equity?
Equity is the portion 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. It is recommended that you print an amortization table to keep up with your equity.
Example: Your home is valued at $200,000 and you owe $100,000 on your mortgage. You have an equivalent equity of $100,000. ($200,000 minus $100,000 equals $100,000) This is the amount you have to do something with if you sold the home or borrowed against it.
How to Build Equity
The more equity you have, the better. There are two ways to build equity:
- The property increases in value
- You pay down the debt portion of the loan or mortgage monthly (Just 1 payment extra per year can reduce a 30 year mortgage down to approximately 21 years)
Increase the Property Value
Your home’s market value is an important element in your equity calculation. When you home value increases, you have more equity. So how does your home increase in value?
Rising prices in your market: 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 improvements: you can also improve your home to increase its value.
Modernizing kitchens and bathrooms, adding 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).
Keep in mind, when you sell, curb appeal, kitchens, and bathrooms sell houses.
If you’re doing improvements mainly to build equity, pick projects with the highest return on your money spent for the improvements.
Always maintain your property: 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. Besides the fact that deferring work needing to be performed should be performed as it is needed because waiting can cause other issues.
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: if you have a 30-year mortgage, you can move the debt reduction along by paying more than is required. Each extra dollar you pay goes to the principal, therefore, increasing the amount of equity in your home. Make sure your lender applies those payments to the principal. There’s nothing to prevent you from paying from a 15-year repayment schedule and making those payments on your 30-year loan. If things change at some point and you can’t afford to do that anymore, 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. If you can just pay 1 extra payment a year, you can reduce a 30-year loan by several years.
Don’t cash out the equity: second mortgages and refinancing can interfere with debt reduction. If you can save by refinancing, go ahead. But just 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. Also, remember every time you refinance or borrow, you have closing cost. These closing cost can be from several hundred to several thousand.
Forced Savings
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 in an asset (this is like money in the bank). With a home, the asset is not like 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 the equity you have
- If you're buying another house, you can use the equity monies to help with the purchase of your new house which means you will need to borrow less
- If you are selling to downsize, because you no longer need a large house, you may be able to pay all cash
- 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")
- Start a business
- Pay for your children's education
Always remember that most people who rent all their lives have a net worth of about $5000 later in life. Someone who is a homeowner is usually worth about $172,000.
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