Building equity in your home can be not only a reliable way to create wealth but can also help you maintain ownership while living in it.
What is Home Equity?
Home equity is the part of your home that you own outright. If you have paid off your mortgage or purchased the home entirely in cash, you own 100 percent equity. Otherwise, home equity is calculated by subtracting your mortgage balance from the current market value of the home. Let’s say your home is worth $350,000 and you owe $150,000 on your mortgage. To calculate your home equity, you can use the following calculation:
350,000 – 150,000 = 200,000
If you’re looking to get a home equity loan or a home equity line of credit (HELOC), it’s good to know how much equity you have, as lenders determine borrowing amounts based on that equity. Generally, the more equity you have, the larger amounts you can borrow. Knowing how to build equity in your home helps you create a valuable asset over time and increase your net worth.
Why is Building Equity in Your Home Important?
Building equity in your home is important for several reasons. It can be not only a reliable way to create wealth but can also help you maintain ownership while living in it.
Building equity in property means:
You can use your home equity for almost any purpose. Homeowners can borrow against the value of their homes through home equity loans and home equity lines of credit. With a home equity loan, you receive all the money in one lump sum and begin repaying the loan over a term of up to 30 years. When you get a line of credit or HELOC, you have a draw period (usually five to ten years) during which you can withdraw the cash you need when you need it and pay only interest. After that, you have a repayment period (usually ten to twenty years) during which you pay back both interest and principal.
You are likely to make a profit when selling the home, even if you have a loan balance outstanding. Building equity means you have a much better chance of selling the property for more than you owe on the mortgage, even if the market goes down. You can use the profits from the sale to buy another home, pay off other debts, or invest elsewhere.
You can build long-term wealth. Building equity in home can help increase your net worth over time, especially if you bought your home when the market favored buyers. A home is one of the few types of assets that has the potential to appreciate in value (for example, cars depreciate over time). It can also provide a source of wealth for your descendants.
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 increasing the value of your property or reducing your mortgage debt, or some combination of both. Here are some options available to homeowners.
1. Make a Large Down Payment
Building equity in your home starts the moment you make your down payment. Remember: home equity equals the amount you own in the home outright, and you own outright what you actually pay from your pocket (rather than financing with a loan). So the larger the cash amount you put down to buy the home, the greater your share of equity.
On
Although it may be possible to buy a home with a 3 percent or even 0 percent down payment, a larger down payment immediately enhances your equity in the home. The percentage of the house that you are financing, you do not own – the bank does.
When calculating your down payment, consider the savings you will have after closing. If you leave yourself with little or no cash reserves, it will be more difficult to deal with any financial emergencies that arise and it may also make it harder to cover the regular monthly mortgage payment. You will also need to account for home maintenance costs, which typically run about 1 percent of the home’s value in the first year.
2. Avoid Private Mortgage Insurance
If you can put down at least 20 percent of the home’s value when buying, you will also avoid the monthly payment for private mortgage insurance (PMI). It’s an additional fee built into the mortgage payment – a burden you don’t need. Avoiding adding PMI (or MIP if it’s a government-backed loan) to your mortgage payment can free up money each month and help increase the equity in your home.
3. Pay Closing Costs Out of Pocket
When you take out a mortgage, you may get an offer from your bank to roll any closing costs into your mortgage. Obviously, this is tempting, as those costs can total several thousand (up to 5 percent of your loan). However, doing so increases the monthly amount (principal and interest) that you pay.
Paying closing costs and other fees upfront, if you can afford it, is a more economical step. This will help boost your equity because it means more of your money goes toward principal, keeping that principal (and the amount of interest charged on it) smaller. This strategy applies to mortgages, but it can also apply when you take out a refinance loan, which also includes closing costs and fees.
4. Increase Property Value
You can increase your home’s value by making improvements, thereby increasing your equity. But remember that you likely won’t recoup all the money you put into home projects. Some projects yield a better return on investment than others.
For instance, according to the “Cost vs. Value 2023” report from Remodeling, a luxury bathroom remodel returns an average of 66.7 percent on investment, and a simple kitchen remodel averages an 85.7 percent return on investment. The project that provides the greatest return per dollar invested is converting an HVAC (heating, ventilation, and air conditioning) system from a fossil fuel-based system to an electric system, which provides a return of 103.5 percent.
Before embarking on your home renovations, make sure to research first, or consult a real estate agent or another home professional to get an idea of the improvements that offer the greatest return. The goal is to avoid putting too much money into renovations that do not significantly increase your home’s value. An expert can help you sort through options and choose projects – even the details – finishes, features, and appliances – that provide the most reliable return for your efforts. Sometimes, less is more: while a simple kitchen remodel returns an 85.7 percent ROI, a large kitchen remodel only returns 41.8 percent.
5. Make Larger Payments on the Mortgage
Most
Mortgage loans follow an amortization schedule, which means you make payments in installments over a specified period until the loan is paid off. As you pay down your mortgage, your equity stake in the home increases. While you will always pay both principal and interest, a larger portion of the payment goes towards interest at the beginning, and then more goes towards principal over time.
However, if you make extra payments towards the principal each month, you build equity in the home faster by reducing the total amount owed on the debt. If you have the means to pay a little extra, contact your loan provider and inquire about how to do this. Check your monthly statements to ensure that the extra money is going towards the principal.
Here are some ways to pay off your mortgage faster:
- Switch to bi-weekly mortgage payments. Divide 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 each year, ultimately shortening the loan duration and saving you money on interest.
- Add a specific amount each month. Check your budget to see what extra amount you can realistically put towards your mortgage each month. For example, if you’ve just paid off a car loan, consider putting that extra $250 toward your mortgage each month.
- Use windfall money. Anytime you receive a tax refund, work bonus, or cash gift, put it towards your mortgage balance.
When you are aggressively paying down your mortgage, make sure you’re not leaving yourself cash-poor each month and relying on credit cards to meet basic needs. And while reducing debt is never a bad thing, making your money work for you – that is, investing – is also important. So, don’t neglect active efforts to build wealth, such as funding an IRA or 401(k) account.
6. Refinance to a Shorter Loan Term
A shorter loan term has two major benefits: you typically get a lower interest rate, and more of your mortgage payment goes towards the principal each month. Choosing a 15-year loan from the start helps you build equity faster each month than you would with a 30-year loan, because you’re paying off the debt more quickly. If you already have a mortgage, you can refinance it to a shorter-term loan.
However, there is a caveat: payments are higher on a shorter loan. Make sure there’s room in your budget for these higher mortgage payments before choosing a shorter loan or refinancing to a shorter loan.
Also, because of the higher payments, it may be harder to qualify for a shorter loan. To qualify, you’ll need a higher income, a better credit score, and a lower debt-to-income ratio than you would typically need with a traditional 30-year mortgage.
7. Wait for Your Home Value to Increase
Local housing markets change over time, so your home value may fluctuate. When home prices in your neighborhood rise and demand increases, your home value goes up.
Conversely, when home prices drop, you may lose some equity. To protect against this type of market fluctuation, it’s wise to avoid borrowing too much equity from your home. When you do draw from equity, use the money to make value-adding improvements to the home that can also help protect your property value. While you don’t have much control over real estate market fluctuations, it’s good to consider this factor. You can check your home value using an online home price calculator or by consulting a professional appraiser.
8.
Avoid Cash-Out Refinancing
If you’re refinancing your mortgage, avoid cash-out refinancing if you can. In cash-out refinancing, you replace your old mortgage with a larger mortgage; the additional amount you receive in cash (hence the name). This amount is calculated based on the equity you currently have in the home.
Simply put, you are borrowing against your share of the equity – which actually reduces it. You are pulling equity out of the home, in other words. It’s not good if your goal is to increase your equity.
Cash-out refinancing can be beneficial. But in this case, it works counter to the goal. Stick with rate and term refinancing, which may allow you to benefit from a lower interest rate or a shorter loan term while keeping your equity intact.
How Home Values Will Affect Equity in 2024
It’s clear that home equity goes hand in hand with property values in general. During the peak of the pandemic, home prices skyrocketed for various reasons: a lack of available inventory, record-low interest rates, and intense buyer demand. This powerful trio sent homeowners’ equity values soaring.
However, the real estate landscape differs significantly in the post-pandemic world. In many areas across the country, the housing market has slowed or cooled significantly thanks to a harsh mortgage interest rate environment. As a result, fewer homes were available in 2023 and fewer sales occurred.
Mortgage interest rates are expected to dip slightly in 2024, and home sales are likely to increase a bit, but not dramatically. This is primarily because mortgage interest rates are expected to remain above 6 percent next year.
There will also likely be more inventory available in the market over the next year. But again, don’t expect a significant increase in the amount of properties available for sale. Many current homeowners may still be reluctant to list their homes on the market and lose the low-interest rates they secured in days gone by to buy a new home.
So, what do these market dynamics mean for home equity? It’s unlikely that values will drop significantly due to the scarcity of inventory. This reality will keep home prices elevated, along with equity for homeowners. While the days of rapid rises may be over, value increases will still occur. The CoreLogic “Home Price Insights” report predicts that prices will rise year-over-year by 4.5 percent from May 2023 to May 2024. This is good for building equity.
$300,000
The approximate amount of home equity owned by the average American homeowner
Source: CoreLogic Homeowner Equity Report – Q3 2023
Final Takeaway on Building Home Equity
Building equity takes time, but it’s worth it. Making a big down payment, increasing the value of your property through improvements, and paying a larger amount on your mortgage each month are some ways to increase your equity stake.
Source: https://www.aol.com/build-equity-home-why-185116885.html
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