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One of the biggest financial arguments for purchasing a home is that it allows you to build equity. You may have also heard it’s one of the most straightforward ways to build wealth. But what does that mean?
We’ll explain what equity is, why it’s beneficial for homeowners and the different ways you can use it to your advantage.
What Is Home Equity?
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Equity means ownership. The more equity you have, the more of your home you actually own. Financially, the more equity you have, the more of your home’s market value you can leverage.
When you take out a mortgage to buy a house, the bank or lender technically puts most of the money down for it. Because they’ve paid for most of it, they effectively own most of it, even though the deed is in your name.
The proof of this is the lien that’s put on the property. If you don’t pay back the mortgage loan, the lender has the legal right to claim your property.
Once you’ve paid off the mortgage in full, the lien is removed and you own the home outright.
How To Calculate Your Equity
Most mortgages have loan terms of 15 or 30 years. As you make payments over the years, your equity in the property will increase as the outstanding amount owed on the mortgage decreases.
To calculate your home equity, take the current value of your home and subtract the principal you still owe on the loan (home value – mortgage principal remaining = your equity).
Here’s an example with numbers:
- Estimated property value = $350,000
- Mortgage principal remaining = $275,000
- $350,000 – $275,000 = $75,000
- Your equity = $75,000
One huge benefit of purchasing a home is that any home appreciation – aka increase in property value over time – automatically goes to you and increases the value of your equity. Ideally, this will happen naturally as you pay off your mortgage.
Historically, homes tend to appreciate in value over time. However, markets do fluctuate, and if there’s a market downturn, your equity could drop.
Strapped for cash?
Your home’s equity is your money. So whether it’s for a new kitchen or consolidating debt, a cash-out refinance can help get you there.
Benefits of Home Equity
Several benefits come with increased home equity that don’t require you to tap into those funds.
Cancel private mortgage insurance (PMI)
If you put less than 20% down on your home, you’ll likely owe private mortgage insurance (PMI) – although there are some exceptions. This is an additional cost your mortgage lender will factor into your monthly payment.
However, once your equity hits 20%, you can ask the lender to remove PMI from your monthly payment. This can lead to significant savings.
Generally, you can expect to pay $30 – $70 per month in PMI for every $100,000 borrowed. For example, if you borrowed $200,000, that’s $720 – $1,680 per year.
Increase your net worth
The amount of home equity you own and its value contributes to your net worth. As you make mortgage payments and your equity increases, your net worth will also increase. This has multiple benefits, including security and flexibility, as well as more options for retirement planning.
Peace of mind
For many, owning a home with significant equity provides a sense of stability and security. Just knowing you have the ability to tap into it, even if it’s not your first option, can ease anxiety and stress – especially when things go wrong. Think of it as having a “break glass in case of emergency” option.
That said, financial professionals still recommend having an emergency fund that can be tapped into quickly.
Should You Borrow Against Your Equity?
As your home equity accrues, you may be tempted to borrow against it. A common reason people choose to do this is to finance home improvements to increase the value of their property even more. People may also choose to use it to consolidate debt or cover other expenses.
We’ve put some pros and cons together so you can weigh them for yourself.
There are few restrictions on what you can use the funds for, and depending on your equity, you can obtain a substantial amount of cash.
The loans that allow you to access your equity almost always have lower interest rates than credit cards or personal loans. This will save you money as you repay what you borrowed.
If you use the funds for home improvements, the interest you pay on the loan might be tax deductible.
When you borrow against your equity, you’re borrowing against your home. Your property becomes the collateral. If you don’t repay the loan, the lender has the legal right to claim the property.
Whatever you use the loan for, you’re taking on more debt. That means you’ll have to pay it back, and you’ll owe interest on it. More debt also affects your debt-to-income (DTI) ratio, which can affect your ability to qualify for other loans.
Some of the loans that tap into your equity have variable interest rates. That means you could end up paying more if interest rates rise in the future.
How To Access the Equity in Your Home
Regardless of why you might want to tap into your equity, you have a few different options for doing so. Here are the most common ones:
- Home equity loan: This is considered a second mortgage on your home. You’ll receive a lump-sum payment from the available equity you decide to borrow.
- HELOC: A home equity line of credit (HELOC) gives you a line of credit you can draw from. The credit limit is determined by what the equity in your home is worth. HELOCs come with a draw period, during which you can take out as much as you’d like up to your credit limit. Once the draw period ends, you’ll be responsible for repaying the full amount.
- Cash-out refinance: Taking a cash-out refinance gives you a new mortgage with a higher loan amount. Essentially, you borrow more money than you currently owe and get the difference in cash. This is usually the way to take advantage of your equity with the lowest interest rate.
- Reverse mortgage: This is an option for homeowners who are 62 or older. With a reverse mortgage, the lender gives you a monthly payment as long as you remain in the home. The loan must be repaid with interest when the borrower dies or permanently vacates the home.
Tips for Building Home Equity
Your equity will increase over time simply by making on-time mortgage payments. But there are some additional things you can do to expedite the process.
- Make a larger down payment: The more money you put down initially, the less you borrow. In addition to increasing your initial equity stake, you’ll also owe less in monthly payments.
- Make biweekly payments: By making payments every two weeks, you’ll make 26 half-payments per year, which totals 13 months of payments. Essentially, you’re paying an extra month off your mortgage each year without feeling the financial strain as acutely.
- Pay more than the minimum amount: When you pay more than the minimum on your mortgage payment, be sure to specify that you want the extra funds to go to the mortgage principal. This will increase your equity and save you money in interest over time.
- Upgrade your home: When you make home improvements that increase the value of your home, that equity is credited to you, not the lender.
Common Misconceptions About Home Equity
There are a lot of myths about home equity that can steer homeowners the wrong way, especially new homeowners. Here are some common misconceptions:
- Home equity is the same as cash: Although equity has value, you can’t access it right away. And unless you access it by selling your home, you’ll need to pay the money back, plus interest.
- Home equity builds quickly: Early on in your mortgage, most of your payments go toward interest rather than the principle of the loan. As you make payments over time, a larger percentage will go to the principal until, eventually, most of your payment is applied to the principal. Mortgage amortization is the name for this process.
- Home equity growth is predictable: Property value plays a big role in your home equity, and that value is subject to economic forces outside of anyone’s control.
Only if you borrow against it. Home equity can still benefit you without tapping into it. For example, you can use it to cancel PMI payments and for future financial planning and peace of mind.
It can be – for example, if you want to use the funds to do renovations that will add value to your home. Just remember, you’ll need to pay back what you borrow with interest, so it wouldn’t be advised to take it out for something like a vacation or frivolous spending.
While “good” is subjective, there’s a term called “equity rich,” which means you own at least 50% of what your home is worth. That’s a good goal to shoot for if you’ve just purchased a home.
There’s a reason equity isn’t considered a liquid asset. You have to do some work to access it. If you don’t want to refinance or take out a second mortgage, you can always sell the home.
Final Thoughts on Home Equity
Equity is one of the biggest perks of homeownership. As your equity increases, so does your net worth and the financial choices available to you. However, if you’re considering borrowing against your equity, take some time to review the different loan options and the repayment terms.
The Short Version
- Equity means ownership. The more equity you have, the more of your home you actually own
- To calculate your equity, take the current value of your home and subtract the principal you still owe on the loan (home value - mortgage principal remaining = your equity)
- To increase your equity faster, you can put down a larger down payment, do home renovations to improve property value and/or make extra mortgage payments
Freddie Mac. “Breaking Down PMI.” Retrieved June 2023 from https://myhome.freddiemac.com/buying/breaking-down-pmi