As a new or soon-to-be homeowner, you’ve likely been bombarded with a slew of real estate jargon recently. One term likely to come up is “What Is Home Equity? Home equity is basically a homeowner’s financial stake in their property.... More.” And understanding what it is and how it works is essential, especially if you’re considering refinancing.
But what is equity in a house exactly? In this guide, we’ll take a deep look at home equity, how it works, and how you can build it up quickly from the get-go.
What Is Equity in a Home?
Almost every homeowner has at least a little equity in their home, even if they’ve just bought it. Home equity is basically your financial stake in your home, i.e., the money you’ve paid toward the house. This typically starts off as the value of your down payment but grows with each mortgage payment you make.
How Does Home Equity Work?
To understand how it all works, it’s helpful to know how to calculate home equity. Fortunately, it’s a pretty easy sum: simply take the value of your home minus what you owe on your mortgage loan, and you’ll get your house equity.
For example, if you purchase a home for $400,000 with a down payment of 20% ($80,000), you’ll need to borrow the remaining $320,000 from a mortgage provider. Once the sale is closed, your $80,000 down payment becomes the equity you have in your home, while the remaining $320,000 is your mortgage. If, however, you only put a 10% deposit down, your equity will be $40,000, while your mortgage will be $360,000.
Even though the lender has put up the remaining cash, they don’t own any portion of your home. Instead, they use the property as collateral if you default on your loan. So, if you miss several payments, the lender can put a lien on your house and take possession—a process known as foreclosure.
Of course, if you don’t take out a mortgage to buy your home and pay the total value in cash, you have 100% equity in your home from the start.
How Home Equity Increases
For anyone who has taken out a mortgage to buy their home, the down payment is just the beginning. Every time you make a mortgage payment, your equity steadily rises while your loan value falls.
Besides making mortgage payments, the most common way for equity to increase is for the home’s value to rise. This can depend on several factors, from an upturn in the local market to renovations carried out on your home.
For example, if your $400,000 home doubles in value the day after you take possession, your equity will grow from 20% (the value of your down payment) to 60%. That’s because, while your mortgage value remains at $320,000, your equity will now be $480,000 from a total of $800,000.
Of course, such rapid increases in value are extremely unlikely, but property values can and do rise.
How Home Equity Decreases
Unfortunately, what goes up can also come down. So, if the value of your property falls for any reason, your equity will also decrease. For example, imagine that the home you bought for $400,000 with a 20% ($80,000) down payment drops to $360,000 the day you take possession. Overnight, your equity will have dropped from 20% to about 11%, or $40,000.
In extreme cases, you can even end up with negative equity. This happens when the value of your home drops below the value of the mortgage you took out to buy it. So, if you purchased a $400,000 home with a 20% downpayment of $80,000, and the property value drops to $300,000, you’d be in negative equity by $20,000.
How Much Equity Do I Have in My Home?
Knowing how much equity you have in your home is essential if you plan to sell or refinance. Of course, you already know the calculation (home value – loan value = home equity), but you must ensure the figures are accurate.
The first step is to have your home appraised by a professional. If you’re applying for a loan, the lender will typically arrange for a professional home appraisal to be carried out on-site. However, you can also organize it yourself. An on-site assessment will give you an accurate valuation, but you can also find free online tools that will provide an estimate.
To find out how much of your mortgage remains to be paid, you’ll need to contact your lender. They can give you the exact figures you need to make the calculation.
Can I Cash Out My Home Equity?
Home equity is considered an asset and goes toward your net worth. However, it’s not a liquid asset, so the funds aren’t readily available. But you can tap into the equity you have in your home if necessary. There are two main ways to do this:
- What is a home equity line of credit (HELOC)? More commonly known as a HELOC, a... More (HELOC)
- Refinancing your mortgage
Both enable you to transform your home equity into hard cash when needed. Most commonly, homeowners will do this if they plan major renovations, hoping to buy a second property, cover unexpected costs such as medical bills, or send the kids to college.
Tips for Building Home Equity
Whether you’ve bought a home or are planning to buy one, several tips can help you build up equity in your home faster. Here are some of the most effective methods:
1. Go Large on the Down Payment
If you haven’t purchased your dream home yet, the best way to get ahead with home equity is to budget for a large down payment. Not only will this reduce your mortgage value, but it will enable you to avoid private mortgage insurance (PMI) if you put 20% or more down.
2. Look for a Low-Interest Loan
Another benefit of a large down payment is that it often enables you to get great rates on your mortgage. The lower the interest rate, the more your mortgage payments will go towards paying off the loan and building equity. A high credit score is also essential, so be sure to boost it before you apply.
3. Pay Your Mortgage Bi-Weekly
While most homeowners pay their mortgage monthly, if you switch to paying every two weeks, you’ll pay 13 full payments each year rather than 12. This enables you to pay off your mortgage quicker.
4. Opt for a Shorter Loan Term
While a standard 30-year loan offers the lowest repayments, a shorter-term loan will reduce the interest you pay in total and enable you to build equity faster.
5. Pump Windfall Cash Into Your Home
From tax rebates and work bonuses to winning lotto tickets and an unexpected inheritance, these unplanned cash injections are ideal for putting into your home to build equity. Most lenders allow you to make lump-sum payments at least annually.
6. Renovate Your Home Wisely
Do your research and invest in renovations that will increase the value of your home.
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