Becoming a homeowner comes with many exciting possibilities. You get to control your monthly housing payment, build credit, benefit from your home rising in value over time, and make the home your own. But there’s another advantage many tend to overlook: home equity. If you’ve been a homeowner for a while, chances are your equity has grown a lot over the last few years. As the value of your home increases over time, equity builds. Equity can be a powerful financial tool that you can use to build wealth.
Here, we introduce you to the concept of home equity and how it can work for you.
What Is Home Equity?
In a nutshell, home equity is the portion of your home that you actually own. More specifically, it is the difference between the value of your home and the balance of your loan, which is known as your principal. So, when you make regular monthly payments on your mortgage, you reduce your principal. This is how you build equity, which represents the percentage of your home that you have paid off.
The amount of equity in your home fluctuates over time as you make more payments on the mortgage, and the forces of the market impact the property’s current value.
How Home Equity Works
If you purchase all or a portion of your home using a mortgage loan, your lender has an interest in the loan until you’ve paid off the entirety of the loan. Initially, you acquire equity in your home with the down payment that you make when you purchase it. Then, it will continue to grow as you make mortgage payments. A specific portion of your payment is assigned to reduce the outstanding principal that you still owe.
Equity can also grow from the appreciation of your property’s value. Factors that affect a home’s value are location, supply and demand, size and usable space, age and condition, upgrades and updates, and more.
You can use your home equity as an asset to borrow against to meet an important financial need.
How to Build Home Equity
You can build home equity in many ways, including:
• When you make mortgage payments: Reducing the outstanding balance on your mortgage is the easiest way to increase your home’s equity. Early in your homeowner journey, most of your payment goes toward interest. But over time, that payment will be put toward the principal balance. So, you pay down your mortgage balance and increase your home equity each month you make a payment. To build your equity even faster, you can make additional mortgage principal payments.
• When you make home improvements that increase your property’s value: Home renovations like kitchen and bathroom upgrades, and additions can increase the value of your home.
• When the property value rises: Property values can rise over time, although this depends on many factors like location and the economy. If you have yet to purchase a home, it may help to look at the historical price data of homes in the areas you’re eying to get a good idea of the market and whether values are rising or falling.
• When you make a large down payment: The more money you pay upfront for your home, the more your initial equity stake.
How to Calculate Your Home Equity
To calculate how much equity you’ve built in your home, estimate your home’s value. You can do this by evaluating recent sales prices of homes like yours in your neighborhood. Then, ask your lender about the remaining balance of your loan. Subtract the loan balance from the estimated balance of your home.
Let’s look at an example:
You estimate that your home is worth $400,000. Your current loan balance is $200,000. Your home’s equity is $200,000.
But what if you wanted to determine your home’s equity early on in your homeowner journey? Let’s say that you purchase a home for $100,000. You made a down payment of 20%. That means you’re borrowing the remaining $80,000 with a mortgage loan. You have an equity stake of $20,000 in the house.
If the market remains constant over the next two years, and you’ve applied $5,000 of mortgage payments to the principal, you’ll have $25,000 in home equity at the end of those two years.
But let’s say the market wasn’t constant over those two years. Imagine that your home’s value increased by $100,000, instead of staying the same. You applied that same $5,000 in mortgage payments to the principal. That means you’d have home equity in the amount of $125,000.
Ways to Use Your Home Equity
So, you’ve built equity in your home over the course of several years. What is the point? What does it mean for you?
You can put your home equity to work for you in many ways:
• Remove private mortgage insurance (PMI)
• Make home improvements
• Pay for college
• Consolidate high-interest debts
• Reinvest in your current home
• Buy a new home
You can access your home equity through:
• Cash-out refinance: This allows you to take out your equity by getting a new mortgage at a higher loan amount. The difference between the amount of your current mortgage and your new mortgage is the amount in cash you receive.
• Home equity loan: This is a second mortgage on your home. Unlike the cash-out refinance, it doesn’t replace your current mortgage. You’ll have two mortgage payments and will receive a lump-sum payment from your lender.
• Home equity line of credit (HELOC): This is also a second mortgage on your home. The difference is the HELOC allows you to withdraw money from a line of credit when you need it.
• Reverse mortgage: This type of mortgage allows homeowners age 62 or older to tap into their equity. The reverse mortgage pays off the rest of your mortgage. Then, the rest of the money comes to you. You can receive the money as income, a line of credit, or a lump sum payment.
Armed with new knowledge about home equity, you can tap into the potential of your property to achieve financial goals and fund significant expenses. Whether you want to consolidate debt, make home improvements, or pay for higher education, understanding your home equity gives you the leverage to make informed decisions and unlock your property’s value.