If you’re a homeowner, the mortgage payments you’re making every month can help you build a powerful asset: home equity. Home equity represents the amount of your home that you own free and clear from the remaining balance on your mortgage. The amount of equity you have in your home can grow over time, allowing you to build wealth.
Increasing home equity is an important part of homeownership because it’s a resource that can be converted to cash when expenses arise. Equity can be tapped to pay for remodeling, cover the cost of college tuition or other major financial needs. Homeowners can draw from their home equity in several ways, including using a home equity loan or home equity line of credit (HELOC) or waiting to cash in the equity when you sell the home.
What is equity?
Home equity is the portion of your home that you own, calculated by subtracting your mortgage balance from the home’s market value.
Say your home is worth $250,000 and you owe $150,000 on your mortgage. To determine your home equity, you would use the following calculation:
- $250,000 − $150,000 = $100,000
If you’re looking to take out a home equity loan or line of credit, it’s good to know how much equity you have because lenders set borrowing amounts based on that equity. Generally, the more equity you have, the more money you can borrow. Knowing how to build equity helps you create a valuable and meaningful asset over time.
Why building equity in your home is important
Building home equity is important for a few reasons. It can not only be a reliable way to create wealth but can also help you maintain the home while you’re living in it.
Building equity in a property means:
- You can borrow equity for nearly any purpose. Homeowners can borrow against the value of their homes through home equity loans and HELOCs. With a home equity loan, you receive all funds at once and immediately start paying the loan back over a period of up to 30 years. When you take out a line of credit or HELOC, you have a draw period (often up to 10 years) when you can withdraw the cash you need when you need it and make interest-only payments. You then have a repayment period (typically 10 to 20 years) during which you pay back both interest and principal.
- You will make a profit when you sell the home. You don’t want to find yourself “upside-down” in a home, owing more on the property than you can recover in a sale. When this happens, the only way to sell is by getting your bank to agree to a short sale. Building equity means you will sell the property for more than you owe on the mortgage. You can use the profits from the sale to purchase another home or pay off other debt or invest it elsewhere.
- You can build long-term wealth. Building home equity can help you increase your wealth over time, especially if you purchased your home when the market was in the buyers’ favor. A home is one of the only assets that have the potential to appreciate in value as you pay it down.
How to build equity in your home
There are a variety of ways to build equity in your home more quickly. The process generally involves taking steps to either increase your property’s value or decrease your mortgage debt, or some combination of both. Below are a few options available to homeowners. And remember, there’s no limit to how many of these steps you can take to increase your equity.
Make a big down payment
Your down payment kick-starts the equity you build over time. Depending on your mortgage options, you could put down as little as 3 percent or even 0 percent when you close on the purchase of a home. The important point to remember however is that starting with a larger down payment instantly boosts your equity in the home. This is one of the quickest ways to reduce the total amount owed on the property and achieve greater home equity. As an added benefit, if you can put down at least 20 percent on the home purchase, you’ll also avoid paying private mortgage insurance or PMI each month.
When figuring your down payment though, consider how much savings you’ll have remaining after closing. Leaving yourself with little to no cash reserves may make it harder to handle any financial emergencies that arise and can even make it more challenging to cover your regular monthly payment.
Increase the property value
Making improvements to your home can also boost its value more quickly, and therefore your equity. Just keep in mind that you likely won’t recoup all the money you put into home projects. Some projects offer more return on investment than others. According to Remodeling Magazine’s 2021 Cost vs. Value report, the average upscale bathroom remodel provides a 54.8 percent return on investment, and the average minor kitchen remodel with midrange finishes provides a 72.2 percent return on investment. The project that offers the greatest return on your investment is a garage door replacement, which provides a 93.8 percent return.
Before taking on your next remodel, be sure to do research first. This could include consulting with a real estate agent or another home professional to identify renovations that provide the most return. The goal is to avoid putting too much money into renovations that offer little to no increase in your home’s value. An expert can help you sort through the options and select projects and even finishes and appliances that provide the most reliable payoff for your efforts.
You should also consider how much the home improvement project will contribute to your experience while living in the home. According to a National Association of Realtors report, 74 percent of homeowners had a greater desire to be in their homes after completing remodeling projects.
Pay more on your mortgage
Most mortgages are on an amortization schedule, meaning you make payments in equal installments over a set period of time until the loan is paid off. While you’ll always pay both principal and interest, a larger portion of the payment goes toward interest in the beginning, and over time more goes toward the principal.
However, if you make extra payments toward the principal every month, you build equity quicker by decreasing the overall total owed on the debt. If you have the means to pay a little extra, call your loan servicer and ask how it’s done, and then follow their instructions. Check your monthly statements to make sure the extra money is put toward the principal. Here are a few ways to pay your mortgage off faster:
- Switch to biweekly mortgage payments. Split your mortgage payment in half and send each half every two weeks instead of once at the end of the month. This adds one extra payment to your mortgage every year, which can ultimately shorten your loan term and save you money on interest.
- Add a certain amount each month. Check your budget to see how much extra you can realistically put toward your mortgage every month. For example, if you just paid off your car loan, consider putting that extra $250 toward the mortgage every month.
- Use occasional extra money. Any time you receive a tax refund, a bonus at work or a cash gift, put it toward your mortgage balance.
When paying down your mortgage more aggressively, be sure you’re not leaving yourself strapped for cash each month and relying on credit cards or other forms of debt to make ends meet.
Another factor to consider when deciding how to allocate extra cash is whether you might make more money by investing in the stock market instead of paying down your mortgage more quickly. Mortgage interest rates are at historic lows of around 3 percent while the average annual return on stock investments is about 16.63 percent meaning you might realize a greater financial benefit by investing.
Refinance to a shorter loan term
A shorter loan term has two main benefits: You typically get a lower interest rate, and more of your mortgage payment goes toward the principal each month. Choosing a 15-year mortgage from the start helps you build more equity every month than you would with a 30-year mortgage. If you already have a mortgage, you can refinance into a shorter-term loan.
However, there’s a catch: Payments are higher on a shorter loan term. Make sure there’s room in your budget for that larger mortgage payment before you refinance.
There’s also no guarantee you will qualify for a refinance. To do so, you will need to have good credit and a reasonable debt-to-income ratio, among other factors. Before applying for a refinance be sure to check your credit profile and address any issues that could be red flags for lenders. You can check your credit score for free once each year at AnnualCreditReport.com.
Finally, when refinancing to a shorter term you may want to avoid a cash-out refinance, which will result in a bigger balance owed on the mortgage.
Wait for your home value to rise
Local housing markets change over time, so your home’s value may fluctuate. When home prices increase in your neighborhood and demand grows, the value of your home naturally rises. In 2021, home values in the United States increased 19 percent. Depending on where in the country you live the values may have increased even more. In Phoenix, Arizona values rose 32 percent in 2021. This appreciation in home value boosts the amount of equity you have.
Conversely, when home prices drop, you may lose some equity. To help protect yourself from this type of market shift, it’s a good idea to avoid borrowing too much equity from your home. When you do withdraw equity, using the money to make valuable home improvements can also help protect your property’s value. While you don’t have much control over real estate market fluctuations, it’s good to keep this factor in mind. You can check your home’s value by consulting with The Cal Yoder Team.