Homeownership is one of the most considerable expenses most people make in their life, but it’s also a straightforward path to building wealth. The key to building wealth is to grow your home equity, which gradually shifts your initial debt into an asset.
Today, Millennials make up 43% of US home buyers and spend the highest percentage of their income on homeownership costs. According to a recent Hometap report, Millennials are at the greatest risk of being house-rich but cash poor. However, many don’t know the amount of equity they have accumulated in their homes or how to calculate it.
According to M Report, the Hometap survey discovered that the COVID-19 pandemic affected the finances of 47% of the respondents, with another 77% carrying some form of financial liability. In addition, Millennials are 83% more likely to carry debt than baby boomers, while 52% of homeowners spend over 16% of their income on mortgages, with one in three Millennials spending over 26%.
The study also discovered that many US homeowners don’t realize their homes provide a source of tappable home equity, so they miss out on opportunities to capitalize. A staggering 43% of homeowners don’t know how to calculate the wealth in their home, so they don’t understand how much equity they have.
What is Home Equity?
Home equity is the difference between a property’s current market value and the outstanding balance of all its liens. It’s how much a homeowner owes on their mortgage and other debts secured by the home. A mortgage is a form of a lien on a home but isn’t a negative thing. Just as having credit is a healthy thing for a credit score, so is having a mortgage on your home.
How to Calculate Home Equity
As a homeowner, you likely acquired your initial home equity with a down payment made to purchase the property. From there, your home equity increases in two ways:
- Making payments on the principal on your mortgage
- When the value of the property increases in the marketplace
Therefore, home equity is the ownership you built in your home since you purchased it through mortgage payments and appreciation. For example, let’s say you buy a house for $280,000 with a down payment of $60,000 and a mortgage for the other $220,000. At this point, your home equity is equal to the down payment you made of $60,000.
Over the years, you pay down $40,000 of your mortgage debt principal, meaning you still owe $180,000. However, in the same period, your home’s fair market value increases to $320,000. So now your home equity is $140,000, or the difference between your current home worth ($320,000) and what you owe (180,000).
How Does Home Equity Work?
Building home equity is similar to investing in a long-term instrument, such as bonds. Your money is locked up and not spendable – for the most part. While there are some ways you can tap into your home equity, you generally create wealth over the years when your share of the property’s ownership increases.
Building home equity is a lengthy financial process. However, immediate market conditions can lead to steep gains or losses. For example, rising home prices following the COVID-19 pandemic contributed to a significant equity increase for many homeowners across the US. As a result, Forbes reported that homeowners gained over $3.2 trillion in home equity in the third quarter of 2021.
On the other hand, plummeting home sale prices have reduced homeowners’ equity. For example, median home sale prices fell by 33% across the US in 2008.
From the example above, let’s say your $280,000 home falls to $165,000 due to a housing meltdown. So even if you paid a deposit of $60,000 and have paid $40,000 in mortgage debt principal, you still owe $180,000. Since your home’s value has reduced by $115,000, you now owe $15,000 more than your home’s value, meaning you have no equity.
5 Ways to Build Home Equity
Making a Significant Down Payment
The equity you create in your home is directly proportional to your initial deposit. So if you bought a $180,000 house and put down only $10,000 as the initial deposit, you still owe $170,000 on your mortgage. It leaves you with only $10,000 in equity. However, if you put down $50,000, that’s a more impressive figure than $10,000.
Focus on Paying Off the Mortgage
A portion of your mortgage payments reduces the principal loan balance, while the rest pays the loan interest, homeowner’s insurance, and property taxes. Therefore, a considerable chunk goes towards your interest when making your early mortgage payments. But, eventually, more goes toward reducing your principal balance.
However, if you took a non-amortizing mortgage such as an interest-only mortgage, your payments only go towards paying your loan interest, insurance, and property taxes. You will later make a lump sum payment to offset your principal balance.
Pay More than the Minimum
Paying more than the monthly required minimum will help you build equity faster. It will also cut down on the amount of interest you’re paying in the long run because you’ll pay the house off sooner than the length of the mortgage.
Stay in the Home for at Least Five Years
You build home equity if the property increases in value. Of course, there is no guarantee of a value jump, but you can increase your odds by remaining in your residence for over five years for an equity boost. It’s also more likely that a neighborhood will improve over the long term, thus adding value to your property’s appeal to future buyers.
Make Improvements to Your Home
Apart from your home increasing in property value through the neighborhood or area you live in, home renovations and improvements can help boost home equity as well. It’s important to plan your improvements wisely though. More affordable changes like a fresh coat of paint or repairing the flooring in a property can bring the value much higher than the actual cost of materials and labor for those jobs.
However, you shouldn’t get carried away with upgrades because it’s not always worth the upfront cost. Home improvements should be appealing to future buyers (and ultimately the appraiser) for the price point where your home is at. Adding imported Italian marble to the kitchen might sound nice, but it won’t be appealing to someone buying a home at a $200,000 price point.
Why is Home Equity Important?
Home equity is important because you can turn home equity into a long-term strategy for building wealth. For example, making mortgage payments reduces what you owe while your home gains value over time, making it a sort of “forced savings account.” A home is likely the most valuable asset many people own.
Many homeowners grew their equity significantly following the COVID-19 pandemic of 2020, with over a third of US mortgaged properties considered “equity rich” – meaning the property debt was at 50% or less of its current market value.
How to Use Home Equity
Americans invest heavily in their homes. However, many don’t know or appreciate their home equity and view homeownership as a debt source. You can tap into your home’s equity when you decide to sell it and move to a larger, more expensive one. Alternatively, you can use that equity for home improvement projects, plan for your retirement, or consolidate other debts.
Borrowing Against Home Equity
Home equity is not liquid, so it’s impossible to sell it as a commodity. However, financial institutions will lend against it in several ways, including a home equity loan, a cash-out refinance, a reverse mortgage, or a home equity line of credit (HELOC).
Using your home equity to borrow money is wise since it comes with lower interest rates than credit cards or personal loans. However, it’s worth noting that failure to make timely payments could result in foreclosure.
How to borrow against your home equity:
- A Home Equity Loan: Its’ also called a second mortgage, a lump sum loan you must repay over a fixed period. The amount you qualify depends on your home equity, and lenders will require monthly payments, similar to a regular mortgage. Interest paid is tax-deductible on your federal tax returns.
- A HELOC: You can borrow money using your home equity as collateral. The lender bases the HELOC amount on a percentage of your home’s equity, and you can borrow against it regularly. Interest paid is tax-deductible on your federal tax returns.
- Cash-Out Refinance: It allows you to refinance for more than you owe on your mortgage, and you can receive the extra money in cash. However, your cash-out refinance depends on your home equity.
- A Reverse Mortgage: It’s available to homeowners over 62 years old under a federal program from the Department of Housing and Urban Development. If eligible, you can access a portion of your home equity when you borrow against it. Additionally, you can opt to receive monthly payments, take it in a lump sum, arrange a line of credit, or use a combination of the three. The government defers your obligation to repay until your death, or you sell the home.
Home equity is just a small part of the homeownership process and understanding it can help you determine your long-term financial goals related to your home. It’s important to consider when making further investments in your home or additional properties that you may consider.
PropLogix works with title agents and real estate attorneys primarily, but we believe in bringing transparency to every real estate transaction.
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