One of the best things about owning a home is building equity.
And it’s been a very good year for homeowners in this regard. A Zillow analysis found the housing market gained more value in 2020 than in any other year since 2005. “With home values and sales moving well, a lot of borrowers who didn’t have much equity in their homes before now have it,” says Ashley Massie, Consumer Loan Processing Supervisor at Telhio Credit Union.
There are things you can do yourself to build equity, such as making extra mortgage payments, which also can save you thousands of dollars in interest. As long as you stay on top of your mortgage payments and your home doesn’t have any significant, lasting drops in value, you are building home equity to free yourself of your mortgage, turn into profit when you sell—or in some situations, borrow against when you need cash.
For example, if you’re evaluating a plan to pay off high-interest credit card bills or other toxic debt, “you should definitely consider your home equity,” says Laura Adams, personal finance author and host of the Money Girl podcast.
What Is Equity?
Home equity is how much your home is worth after subtracting your mortgage balance and any other loans on the property. Let’s say you’re buying a home for $200,000, with a 20% down payment. After closing on your home, and using the $200,000 purchase price as its value, you’ll have a remaining loan principal of $160,000 and your home equity would be $40,000.
|Home Purchase/Value||20% Down Payment||Mortgage Balance||Equity at Start of Loan|
“Home equity is the value of your home minus any mortgages or liens,” says Massie.
Each month, when you pay your mortgage, a part of that payment goes to pay down the principal, and a part is paid as interest to the bank. You can use an amortization calculator to see how much of your payment goes toward the principal (aka your equity) versus the bank (aka interest).
With each monthly payment of $889 based on a 3.2% interest rate using the above example, at the beginning you’d only be gaining $264.33 in equity, with $426.67 going to the bank as an interest payment. As you pay down the balance, more of that payment is credited to your home equity and less is paid as interest, in a process known as amortization.
|Monthly Payment in Year 1||Payment Toward Principal||Payment Toward Interest|
Another factor that affects your home’s equity is the market for homes: if homes like yours start selling for $250,000, you still are only paying on that initial $200,000 loan, so that extra $50,000 in value is added to your home equity. It cuts both ways though: if those same homes start selling for $150,000, you lose $50,000 in equity.
How To Build Equity in Your Home
1. Make a down payment
Your down payment is a great way to kick start building your equity in your home. Lenders often recommend making a down payment — even if one isn’t required. For example, VA loans don’t require a down payment at all, while FHA loans can accept down payments as low as 3.5%.
Nevertheless, making a down payment — of at least 20% if possible — is really important to build equity, reduce the interest you pay on your loan, and also avoid private mortgage insurance (PMI) or mortgage insurance premiums (MIP), which can be an additional cost within the early part of your mortgage that is typically waived with a 20% down payment.
2. Increase property value
Making improvements to your property is a great way to add value to your home and increase its value over time. This is especially important if you intend to sell your home in the future and would like to make a profit. One important caveat is that very few home updates offer a perfect return on investment when you sell your home. Even if you spend $10,000 on an improvement, you may only see a $5,000 or $8,000 boost in potential home sale price.
3. Make biweekly payments
There are smart budgeting strategies to help you build equity faster without feeling a big financial impact. For instance, 26 biweekly payments instead of 12 monthly payments gives you a predictable, smaller payment but ends up paying an extra month of your mortgage each year. Paying off your mortgage earlier than the prescribed schedule builds equity faster but also spares you extra interest costs over the life of the loan.
Here’s an example of how much you can save on interest, and how much more quickly you can pay off your mortgage, by making biweekly payments on a 30- or 15-year mortgage:
|Starting Loan Balance||Loan Term||Interest Rate||Biweekly Payment||Extra Paid Per Year||Interest Savings||Mortgage Paid Off|
|$300,000||30 years||3%||$632.41||$1,264.82||$21,418.07||During Year 26|
|$300,000||15 years||3%||$1,035.87||$2,071.74||$7,864.85||During Year 13|
4. Refinance to a mortgage with a shorter term
You can also build equity faster by refinancing your mortgage to a shorter loan term—preferably with a better interest rate, too. Refinancing is when a bank replaces your current mortgage with a new one with new terms. For instance, you can refinance your 30-year mortgage to a 15-year term instead. With a shorter loan term, you will pay off the loan more quickly, building your equity that must faster. Just keep in mind: With a shorter loan term, may pay a little more each month, but you’ll gain equity faster. But with a better interest rate, if you’re able to get one, more of your payment will go toward paying down the principal balance, which saves you money in the long run.
5. Wait for your home to increase in value
Home equity grows or shrinks in response to the wider housing market. Factors like how popular your neighborhood is, whether the market is experiencing low or high inventory, and the demand for your particular home’s features all influence the current value of the home. Big fluctuations do occur, but the long-term trend is for prices on average to rise. The National Association of Realtors released information in February 2021 about how Q4 2020 showed rising home prices in all metro areas. This is one way for homeowners to gain equity in the home over time.
Many who are interested in taking advantage of their home equity pay attention to similar homes in their area so that they can use home equity during a time when demand is higher and their home is likely to appraise favorably.
How to Use Home Equity
Think of your home equity as your personal stake in a valuable asset: your home. If you choose to sell your home in the future when you still have a mortgage on it, any remaining funds after you pay off the balance are coming to you as cash. You can use this to buy another home. This is one of the most common ways to use home equity.
If you don’t sell, you have other options for borrowing against your home equity. An example geared toward retirees and senior citizens is a reverse mortgage. A reverse mortgage gives you money now as a loan or line of credit, with the caveat that it will be paid back in a lump sum with interest when the home is sold.
“A reverse mortgage can be a clever solution for retirees who have built up a lot in equity but don’t have a lot in the bank account,” says Adams. “You can set it up like a line of credit, too, so that you have it for large unexpected expenses, almost like an emergency fund.”
How to Borrow Against Home Equity
It is important to know the consequences of borrowing against home equity. By putting your home up as a collateral, you run the risk of losing it if you can’t repay. You’re also committing yourself to years of debt payments. If you’re in a solid financial state and you can afford it, there are a variety of products with relatively low interest rates that can help you make big purchases or pay off high-interest debt.
1. Home equity loan
This is a structured loan with a repayment plan that takes a certain amount of the home equity and gives it to you now. This product is a good fit if you have a specific goal for what to do with the money, like paying for a large home improvement.
2. Home equity line of credit
A home equity line of credit (HELOC) is more like a credit card, but with much lower interest because it is secured by your home. Essentially, your lender tells you how much you are qualified to borrow against your home equity, and you can use it or just keep it as a backup way to pay unexpected expenses or take advantage of opportunities in the future.
“We’re big fans of HELOCs for a good percentage of our clients, so they have the ability to access the home equity if a good investment comes up,” says Andrew Comstock, CFA and Principal Wealth Advisor at Beyond Wealth in Overland Park, Kansas. “It can be a secondary rainy-day fund, and it’s prudent to have it available to put into a home remodel or help pay for college.”
3. Cash-out refinance
A cash-out refinance is part of a refinanced mortgage loan, where you start your mortgage over, ideally with a shorter loan term and lower interest rate. You end up with a new mortgage, and cash in your pocket from the equity you’d built in your home. If you can get a shorter loan term, and an interest rate at least 1 percentage point lower than your previous rate, this can be a great option to fund home renovation projects, college tuition, or even debt consolidation.
However, keep in mind that a cash-out refinance could cost you more in the long run if you aren’t getting a shorter loan term and lower rate (and the lower interest costs that come with it). Do the math to make sure you know how much you’ll pay in new interest costs over the life of the new loan, compared to the equity you cashed out in the refinance.
You can think of your home equity as the percentage of your home that is fully yours at this moment in time: the total value, less any mortgage or loans on it. While most homeowners still have a long time until they pay off their mortgages completely, they can access the value they’ve built through credit or loan products that are secured by the long-term value of the home. Alternatively, you can choose to build equity more quickly, and become debt free sooner, by making extra payments to your mortgage.