Building equity is one of the primary financial benefits of homeownership. You don’t notice it while it’s happening, but if all goes well, you end up with a significant asset that you can use for almost any financial need.
- Equity is the portion of your home that you own after subtracting any debt you still owe against it.
- You can use your equity to finance other needs, such as home improvements or education, or convert it to cash when you sell the home.
- You increase equity in two ways: by raising your home’s value or lowering your mortgage debt.
What Is Equity?
If the result is a negative number, the home is worth less than the amount you owe on it, and you have negative (“upside down”) equity.
Example: Your home is worth $250,000, and you owe $100,000 on your mortgage. $250,000 minus $100,000 equals $150,000 of equity in your home.
What can you do with your equity? Equity is a valuable asset, and it can enable you to:
- Receive cash after you sell the home and pay all related costs.
- Borrow against it with a home equity loan or home equity line of credit (HELOC).
- Use it for a down payment on your next home purchase.
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How to Build Equity
The more equity you have, the better off you’ll be. There are two basic ways to build equity in your home:
- The property value increases; and/or
- The amount of debt decreases
It’s fairly simple: You build equity when you increase how much higher your home value is than the remaining debt on the home.
Increase the Property Value
Your home’s market value is an essential component in your equity calculation. If the home’s value rises, you instantly have more equity. So, what makes home prices head upward?
Rising prices in your market: If you’re fortunate, home values in your market could increase over time without any action on your part. That’s most likely to happen in attractive neighborhoods or growing towns.
Home improvements: You can also invest in your home to increase its value. Updating kitchens and bathrooms, improving landscaping, and investing in energy-efficient upgrades can all pay off. But those projects cost money upfront, and you need to be confident that you can more than recoup those costs. If you’re making improvements with the primary goal of building equity, select projects with the highest return on investment (ROI). Don’t automatically assume that any improvements-cosmetic or otherwise-will lead to higher property value.
Upkeep: Routine maintenance is tedious (and it costs money), but a home that’s falling apart is not appealing to potential buyers. If you fail to address maintenance issues like leaks and deteriorating roofing, your home equity may decrease over time. If you decide to put your home on the market, you may need to spend the money in order to sell it anyway.
Reduce the Debt
Monthly payments: With most home loans, you pay down your loan balance a little bit with each monthly payment. A basic amortization table can show you the process in action. The longer you have your loan, the more principal you pay. (More of each payment goes toward equity, and less of each payment evaporates in interest charges.) This process is automatic on most loans.
If you just keep making payments on time, you build momentum. You then make increasingly large principal payments throughout the process, without even trying.
That’s the passive approach to eliminating debt. But you may want to accelerate the process and build equity more quickly. Here are several strategies for doing that.
Choose shorter terms: Shorter loan terms cause you to pay down debt and build up equity more quickly than you do with long-term loans. For example, a 15-year mortgage would be better than a 30-year mortgage if your primary goal is to build equity. As a bonus, lower interest rates often accompany those shorter-term loans. A low rate, combined with the fact that you’re paying interest for fewer years, means you’ll spend less on interest and save money over the life of your loan.
Make extra payments: Even if you have a 30-year mortgage, you can speed things up by paying extra amounts. There’s no law that says you must pay only the amount dictated by your 30-year mortgage agreement. Each additional dollar you pay above your required monthly payment reduces your debt and adds to your equity-just make sure your lender applies those payments to the principal. Nothing is stopping you from setting up a 15-year repayment schedule (see the link to the amortization table above) and making those bigger payments on your 30-year loan. One positive aspect of this option is that if things change at some point, and you can’t afford the higher payment, you have the flexibility to return to the smaller 30-year payment.
If that seems too complicated, just send an extra payment from time to time. Again, be sure your lender applies any extra payments to the principal, not the interest.
Leave it alone: Second mortgages and refinancing can interfere with debt reduction. If you can save a bundle by refinancing, go ahead and do so. Just remember that with most loans, the earlier payments go largely toward interest rather than principal reduction. Every time you start over, you delay (or at least slow down) the equity-building process. Borrowing against your home with a second mortgage or HELOC increases your debt, thus reducing your equity.
Sometimes people refer to a mortgage payment as “forced savings.” You might not think you’re saving any money by making payments each month, but you are building up the value of an asset (as you would build up the value of a savings account by making regular deposits). With a home, the asset is not cash-like in a savings account-it’s equity in your home. The process is slow, and only a portion of your monthly payment goes to equity. The amount increases over time, but starts small.
It typically takes years to build significant equity in your home, and it shouldn’t be your sole investment or asset. As a result, it’s best to borrow only what you need.