We’ve all heard how important it is to grow your home equity when it comes to owning a property. But what exactly does that mean?
In short, home equity refers to the difference between your property’s market value and how much you owe on your mortgage. Your home equity can increase over time as you continue to pay off your mortgage and your property’s value goes up.
In this article, we will go over how to calculate your home equity, how to grow it at a faster rate, and how to use it to your advantage.
So, if you want to learn more, keep reading!
What is Equity in a Home?
Home equity is a calculation that you can use to determine the difference between your home’s value and how much money you still owe on it. The money that you owe will typically include mortgages, whether it is a purchase loan that you received when you were initially buying the house or a second mortgage that you took out down the road.
Home equity example:
Let’s say you purchased a home for $200,000. You make a down payment of 20%, which would be $40,000, and to cover the rest of the purchase, you get a mortgage loan from the bank.
This means that your home equity is 20% of the property’s value, or $40,000. Even though you are the owner of the property, you technically only own $40,000 worth of the home.
Now, let’s say that the housing market has a boom and the value of your property goes up to $400,000. If you have already gotten your mortgage down to $140,000 after making consistent payments over time, then your equity would be $260,000, or 65% of the property’s value.
How to Calculate Equity
You can determine your home equity by dividing the balance of your loan by its market value, then converting the decimal to a percentage by subtracting it from one. Here is the equation written out:
- 160,000 / 400,000 = 0.4
- 1 – 0.4 = 0.6
- 0.6 = 60%
How Do You Build Home Equity?
So you may be wondering, how exactly can you build your home equity? Well, luckily, there are a few steps you can take in order to make this happen over time.
1. Pay Off Your Loans
While it may seem obvious, it’s important to remember that your home equity increases each and every time you make a payment toward your mortgage balance. Most loans for home buyers will be a standard amortization loan, which is a type of loan that requires the homeowner to make scheduled, consistent payments over time.
These payments are applied to both the principal and the interest, and will usually be in the form of monthly payments that will always be the same amount. The amount that goes towards the actual principal will increase over time as you continue to pay off your mortgage, so your equity will be able to grow at a faster rate each year.
Now, if you choose to obtain an interest-only loan or another kind of mortgage that is non-amortizing, you won’t be building your home equity in quite the same way. In this circumstance, you may have to make extra payments in order to reduce your debt and grow your home equity.
2. Increase the Value of Your Property
Your home equity will also grow as your property’s market value increases. While most real estate will appreciate in value over time, you can speed up this process by updating and improving the property. There is a wide range of property upgrades that you can do to add value to your home.
This includes projects such as upgrading the bathroom, remodeling an attic or basement, adding a deck or otherwise improving the outdoor space of the property, or even adding a garage.
However, even if you decide to simply hold onto the property for a while without upgrades, you’ll be able to build equity without any effort whenever the housing market grows.
3. Accelerated Payments
Another popular way to grow your home equity at a faster rate is to make accelerated payments to your mortgage loan, such as switching your mortgage payment schedule to biweekly instead of monthly. Doing this will help you pay off your mortgage quicker, which, in turn, will grow your equity faster.
Most property owners make their mortgage payments on a standard monthly schedule, effectively making 12 payments towards their loan each year. However, there are other options when it comes to making these payments.
For example, if you were to split your monthly mortgage payment into two equal amounts each month, you would be sending in a mortgage payment every two weeks.
This would result in making 26 mortgage payments annually, as 365 days in a year divided by 14 days comes to 26. This payment schedule is essentially equal to making 13 annual mortgage payments.
Before deciding to take on this approach to paying off your mortgage and building equity, it’s important to talk with your lender to ensure that a biweekly schedule is supported.
How to Use Home Equity to Your Benefit
At the end of the day, home equity is an asset. This means that your home equity makes up a portion of your net worth. You have a few options when it comes to deciding how to use this asset to your benefit.
You can take out partial or lump sum withdrawals from your home equity whenever you need to, or, you can save this equity and let it build up over time, passing the assets on to your heirs.
If you decide to use your home equity, there are a few ways that you can put it to work. Here are some ideas:
1. Sell Your Home
If and when you decide to move to a new home, you can take the equity in the home from the money earned from the sale of the property. While you may not be able to use all of the funds from the sale if you still owe money on your mortgage loan, you could always use your equity to either buy a new property or keep it in your savings.
2. Borrow Against Your Home’s Equity
If you decide to borrow against your home’s equity, you can get cash and use it to fund pretty much anything you may need. This can allow you to use your home equity while you still own the property. This is also known as taking out a second mortgage.
While this can be a useful option, your ultimate goal as a property owner should be to build your home equity. With this in mind, it’s important that if you do choose to tap into your home equity, you place the funds into a long-term investment that will benefit you in the future, rather than just spending it.
Ultimately, paying your current expenses with a home equity loan, or a “second mortgage”, can be risky. If you end up falling behind on payments and are unable to catch up, you could very well end up losing your home.
3. Fund Your Retirement
If you’re looking to experience the benefits of your home equity once you have retired, there is an option to obtain a reverse mortgage. These loans can provide income to people who have retired without requiring them to make monthly payments. The loan will simply be repaid once you leave the house.
While this may seem like a good option, these loans can be complicated, as they have been known to create problems for both homeowners and their heirs. The requirements needed in order to obtain a reverse mortgage loan can also be complex, so make sure to do your research and be wary when using one.
How does a Home Equity Loan Work? Types of Home Equity Loans
Home equity loans can be extremely useful if they are used wisely. They may be tempting as they can allow you to have access to large pools of money, often at fairly low interest rates. Further, a home equity loan is often relatively easy to qualify for since the loan will be secured by your property.
Before you decide to borrow money against your home’s equity, it is important to look very closely at each specific loan and how they work so you can fully understand the possible benefits and risks involved with this financial decision.
1. Lump Sum Loan
Using this loan, you can access all the funds from your home equity at once and set up monthly installments of a set price to repay it. The timeline can vary, as it can be as short as five years, or as long as 15 years or more.
While you may end up paying interest on the full amount, these kinds of loans can end up being a good choice if you’re looking for a significant, one-time cash payment. This can help you with a wide variety of expensive situations. Maybe you want to pay off high-interest credit card debt or pay for a big vacation getaway with your loved ones.
With this kind of loan, your interest rate will most likely be fixed, so you won’t have to deal with surprise interest increases down the line. However, you may have to pay a fair amount of closing fees and other related costs in order to take out the loan in the first place.
2. Home Equity Lines of Credit
If you’re looking for a more flexible option to use your home equity, a home equity line of credit can allow you to access smaller amounts of money over time as you need them. This option works similarly to a credit card, as you can take out the amount of money you will need during the “draw period”, as long as your line of credit stays open.
Home equity lines of credit are often the most useful in situations where you are paying for a large project over a long period of time. This could be anything from a large remodel of your home, to college tuition payments, to buying another property, to helping out a loved one who has fallen on hard times.
During the draw period, you must make small payments on your debt. This will end after a certain number of years, usually 10 or 12. Then, you will enter a repayment period where you will pay off all of the debt. This repayment period can include a larger payment at the end.
Home equity lines of credit often have a variable interest rate, so you may end up being required to pay back a significantly larger amount than you initially budgeted for. However, in certain cases, the interest on your loan can be tax deductible. This is dependent on how the funds from your loan were used.
Either way, when using a home equity line of credit, it is important to take high-interest rates into account before following through on this route to avoid being blindsided by unexpected fees.
What Are the Risks of Borrowing Against Your Home Equity?
Now that you know the many ways that you can borrow against your home equity, it is important to be aware of the risks involved.
One risk that you face when tapping into your home equity is the fact that your property will be used to secure the loan. If for any reason you become unable to pay back your loan, the lender could take your property in foreclosure and sell it in order to repay your debt to them.
The lender would aim to sell the property as quickly as possible, meaning it probably would not be purchased for the highest or even its fair market price. If this is a property that you live in, then you would have to find a new place to live, further adding to your financial stress.
For this reason, it is a good idea to avoid using your home equity to purchase anything that does not bring direct value back into your property. Another thing you can do in order to stay on the safe side is to store some cash away just in case you fall on unexpected hard times.
Before you begin to look around for lenders and different loan terms, you may want to check your credit score. To qualify for a home equity loan, you will most likely require a credit score of at least 680.
How Can You Qualify for a Home Equity Loan?
A higher score will give you even better chances of succeeding. In fact, you most likely won’t be able to qualify for either type of home equity loan until you are able to repair your credit score.
In order to successfully obtain a loan, you must prove that you will be able to ultimately pay it back in the end. This means that you will need to provide your credit history, household income, expenses, outstanding debts, and any other relevant financial information.
Another factor to keep in mind when applying for a home equity loan is your property’s loan-to-value ratio. Typically, it is best to keep at least 20% of your home equity in your property.
Bottom Line: What is Equity in a House?
Your home equity is a valuable part of your property ownership and finances.
In order to grow it, it is important to pay off your debts as consistently as possible, and avoid taking out a home equity loan if it does not benefit the overall value of your property.
