Building home equity is one of the main benefits of homeownership. Home equity is the potion of your property that you truly “own.” Of course, you own your home. What we mean by “own” (quotes are key here) is that you borrowed money to buy the property. This gives your lender a bit of interest in the property until you pay off the loan and completely own the home.
Home equity is almost certainly a homeowner’s most valuable asset. Unless you own a private jumbo jet or resort in the Dominican Republic, we can assume your home is the most expensive thing you own. That asset can be used later in life, so it is essential to understand and how it works and how to use it wisely.
Home Equity at Work: An Example
To calculate equity, simply subtract any outstanding balances from the property’s current market value. Your equity will change over time, such as when the property value increases or the loan balance is paid down. If you do the math and come up with a negative number, you have negative equity. That means that home is worth less than what you owe on it. You can probably guess that isn't a good situation to be in.
The easiest way to explain this with an example. Say you purchase that gorgeous Arts and Crafts-style home with the big front porch and built-in bookcases. It cost $200,000. You made a twenty percent down payment and took out a loan to cover the remaining $160,000. At this moment, your home equity is twenty percent of the home’s value. You contributed $40,000, or twenty percent, to the purchase price. So while you “own” the home, you really only own $40,000 worth of it.
Years go by and your home’s value doubles (this isn’t likely to happen, but let’s keep the math simple). If it’s worth $400,000 and you still only owe $160,000, you now have a sixty percent equity stake--for doing nothing. Your home balance hasn’t changed, but your home equity increased.
I bet home equity suddenly seems more exciting, am I right? There are ways to increase your equity. If you pay down the balance of your loan, for example, your equity increases. Most home loan payments go toward both your interest and your principal. Making your required monthly payments alone is enough to boost your equity rate a bit each year. However, if you have an interest-only loan, you don’t build equity in the same way. In this case, you would need to make extra payments to reduce debt and build equity.
You might even accelerate the process to build equity more quickly. For example, a fifteen-year mortgage would be a more efficient way to build equity than a thirty-year mortgage. A bonus is short-term loans often come with a lower interest rate. Spend less on interest for the life of your loan and build equity faster? Sign me up. Even if you have a thirty-year mortgage, you can still keep things moving along by paying extra. Every dollar you pay above your required payment reduces your debt and goes straight toward your equity.
It can also happen without you even trying. Improvement projects or a healthy real estate market increase equity. You might not even notice while it is happening. After some amount of time, you’ve got a valuable asset that you can use for just about anything.
Why it Matters
Equity is an asset, so it’s part of your total net worth. It is not a liquid asset. You can trade this asset for other assets. For example, if you sell your house, you’ll get cash for your equity. If you’re buying another house, you can use that money to help fund the purchase of your new home.
You can also take income or lump-sum withdrawals out of your equity someday. You can sell your home to turn your equity into cash. And once your investment reaches a certain level, it is possible to qualify for a home equity loan or line or credit.
There are two different types of loans. Home equity loans, often called second mortgage loan, allow you to borrow a chunk of your equity for a fixed interest rate over a period.
With a home equity line of credit (HELOC), the loan comes with an adjustable interest rate and usually allows you to borrow up to a certain amount. It functions similar to a credit card, where you can continuously borrow up to an approved limit while paying off the balance.
Why would anybody want to take on another loan? There are many reasons someone would leverage his or her equity. Maybe it’s time to remodel. Or maybe you’re reaching the middle of your career and are beginning to think of easy ways to fund retirement. Perhaps there are medical bills and tuition payments due.
Considering The Time Frame
Unlike mortgages that are typically paid off over a thirty-year period, use a home equity loans and HELOCs a shorter amount of time. If you need another mortgage for short-term projects like remodeling a few rooms in your house and replacing light fixtures, you could try to apply for a five-year loan.
Are There Risks?
Aren’t there always? If you lose your job or have to take on a substantial unplanned financial burden, your house becomes your collateral. That means that by defaulting on your home equity loan, you are giving the lender the opportunity to seize your home and allow it to go into foreclosure. The same thing could happen if you have a home equity line of credit (HELOC).
The bottom line is, when it comes to your home equity, don't borrow more than you need and don't overspend.