Home equity can be a path to financial stability — if you know how to build it.
Home equity refers to the amount of your home’s value you own based on its current market value, less any liens. Most people consider it their most significant financial asset because it contributes significantly to their net worth. Increasing home equity helps you become financially stable. It may also become your lifeline in emergencies since you can borrow from your home equity.
Several factors affect home equity, such as your down payment and your mortgage. Changes in the market may also affect it. If your home’s value increases because of a market boom, so does your home equity.
Knowing Your Stake In Your Home
Before diving into home equity, let's talk about equity first.
In its simplest definition, equity is the value of owning something. Now, let's apply that logic to your home. Home equity refers to the portion of your home's value that belongs to you. Unfortunately, you don't have total equity unless you bought it outright.
As of the second quarter of 2022, the average selling price of homes was $525,000. Most people afforded home prices by purchasing their homes through a mortgage. The bigger the principal on your mortgage, the lower your home equity is. Taking out a second mortgage, which makes your home collateral for your loan, also decreases home equity.
Making payments on your mortgage increases your home equity. You reach 100% equity when you've paid your loan. When your home's value appreciates, so does your equity.
Understanding home equity allows you to make the most of its benefits. For example, the higher your equity, the more proceeds you get to keep if and when you decide to sell your home. You can also loan against your home equity and use the funds for various purposes, including making home renovations, making investments or consolidating existing debts.
However, taking out a home equity loan — also known as a second mortgage — comes with risks. Remember, it puts your house as collateral. Your lender can foreclose your home if you fail to make payments.
Building Your Home Equity
A loan-to-value rate of 50% or lower translates to “equity rich,” and it's something most people hope to achieve. Homeowners are usually encouraged to build home equity because you turn debt into assets.
Good equity makes you financially healthy and can be a possible source of funds during emergencies. Another benefit of building home equity is that it helps you avoid negative equity, where your home's value is so low that selling it won't cover what you owe.
Fortunately, you can apply multiple strategies to increase your home's equity. MoneyGeek's guide explores these further.
- Ways To Build Home EquityDescription
Pay a higher down payment
Some loans only require a minimum down payment of 3% — some don't ask homebuyers for anything. However, your down payment represents how much you own of your home's value. A small down payment might initially make purchasing a home more affordable, but it also means you have very little equity.
If you can put in at least 20%, do so. Not only will it make your loan amount less significant, but it will also eliminate your private mortgage insurance (PMI) premium. That saves you money, which you can later use for mortgage payments.
Go beyond your monthly mortgage payments
When you begin your mortgage repayments, a part of it goes to your principal. As a result, it lessens the amount you owe and increases your home equity.
Additional payments can increase your equity faster. You can also go beyond your monthly required payment. These will allow you to pay your mortgage off earlier.
However, don't forget to review your mortgage terms. Some lenders charge a prepayment penalty.
Choose a shorter-term loan when you refinance
Refinancing your mortgage in a shorter term can help you build equity faster. For example, see if a 15-year mortgage is workable for you if the original agreement was for 30. Remember, paying off your loan gives you 100% home equity.
Consider refinancing when you have a higher credit score to qualify for better interest rates. The less you pay in interest, the more you pay toward your principal.
Invest in home improvement projects
Paying off your mortgage is one way to build equity over time. Another is ensuring your home's value appreciates.
You can invest in projects that increase your home's value. It can be as simple as replacing the garage door or going all-out with a kitchen remodeling — the objective is to increase your home's market value.
Home equity is the remaining amount after subtracting what you owe on your mortgage from your home's market value. Remember that when your home's value appreciates, your loan amount remains the same, increasing the difference.
Wait for your home’s value to increase
Sometimes, your home's value appreciates even if you don't complete any DIY projects. For example, the value of the property your home sits on begins to rise as the need for land increases. Your home's value will also appreciate if business owners open commercial establishments nearby.
However, these market conditions tend to be outside of your control. Depending on them alone to increase your home's value may not be the wisest option as they can also have a negative effect on your home’s value.
How to Calculate Home Equity
You would think that most people know how much home equity they have. As it turns out, many homeowners don't.
Fortunately, calculating home equity is straightforward. Take a look at the formula below.
When you lessen your mortgage balance from your home's current market value, the difference is your home equity. Let's say you purchased your home for $300,000 but owe $230,000 on your mortgage. Your home equity is $70,000.
However, remember that your home's value fluctuates over time. Let's say you appraise your home and find its market value is now $350,000. It means your equity increased to $120,000, even if your mortgage balance is still the same.
Home Equity Examples
Example #1: A Home With No Change in Market Value
Three years ago, Irene and Rhysand were looking for a new home. With a 3-year-old and a second child on the way, their 2-bedroom apartment felt too cramped. After months of searching, they decided to purchase a home in the suburbs with three bedrooms and two baths for $250,000.
Dipping into their savings and using the proceeds from selling their apartment allowed them to pay a 20% downpayment. They then took out a 15-year mortgage, with a monthly amortization of $1,200.
Now, the remaining balance on their mortgage is $156,800. It makes the couple's home equity $93,200.
Example 2: A Home With an Appreciated Market Value
Ted purchased a 4-bedroom, 3-bath family home for $350,000 and paid a $70,000 down payment. He needs to pay $780 a month for the duration of his 30-year mortgage.
Two years after moving in, Ted decides to add a fourth bathroom. After another two years, he remodeled the kitchen.
After five years, Ted is considering taking out a loan against his home equity. After having his home appraised, he found that its market value increased to $400,000. Since he still has $233,200 to pay on his mortgage, he can borrow up to $166,800.
Home Equity FAQ
Not everyone is familiar with home equity — even homeowners may not know how it works and how much they have. These commonly asked questions will help you understand more about home equity.
Expert Insights on Home Equity
Understanding home equity impacts your finances significantly. MoneyGeek explored the practicalities of home equity by reaching out to experts. Their thoughts and advice may guide you in your financial journey as a homeowner.
- What is the value in knowing your home equity?
- There are several ways to build your home equity. What strategies would you recommend to homeowners?
- How can homeowners maximize their home equity?
Licensed Realtor and Co-Founder of We Buy Philly Home
Co-Founder of HomeZada
Financial Advisor at McClurg Capital
Strategist at Awning.com
Purchasing a home is an excellent investment but also entails a lot of responsibility. You must understand home equity. These online references can give you the necessary information.
- 10 Hidden Costs of Buying and Owning a Home: Along with a home’s selling price, you must also prepare for other homeowning expenses. MoneyGeek’s guide details these for you.
- 6 Ways to Finance a Home Renovation: Making improvements to your home is another way to increase home equity. Find out where you can get funds for your projects.
- Home Equity Lines of Credit: How to Apply & Use: Another option for homeowners with equity is a home equity line of credit (HELOC). See if this is a better alternative to a home equity loan.
- Complete Guide to Mortgages: Find all the information you need, whether you’re a first-time homebuyer or refinancing your mortgage.
- Mortgage Calculator: Knowing how much you need to pay toward your mortgage each month is vital. MoneyGeek’s mortgage calculator is a helpful tool for managing your finances better.
About the Author
- Experian. "Why is Building Home Equity Important?." Accessed August 2, 2022.
- FRED Economic Data. "Average Sale Price of Houses Sold for the United States." Accessed August 2, 2022.