What Does It Mean to Build Equity?
If you own a home, one of the benefits compared to renting is that each month you’re making mortgage payments, so you’re building an asset which is equity. Equity refers to the amount of your home that you truly own after you take into account the debt you owe.
To calculate your current equity, you should subtract your loan balance from your home’s market value.
If the number is negative, then your home is worth less than what you owe on it. That means you have upside-down equity.
This is obviously not the goal. The goal is to grow your equity over time as you pay your loan. Until you pay off your mortgage, even though you’re considered a homeowner, your lender still has an interest in your property.
You own your home, but it’s collateral for your loan.
How Does Equity Work?
If you bought a home for $200,000 and you put down $40,000, which would be a 20% down payment, you would then have a home equity interest of 20% of your home’s value. You own the $40,000 of your home right off the bat because of your down payment.
If your home value goes up over time, then while your loan balance could stay the same, your equity could go up. If you bought your home and the market spiked, so your home was worth $400,000, you’d still owe only $160,000, meaning you’d have gone from owning 20% of the home to 60%.
How Can You Build Equity?
The primary way you increase your equity is by paying off your loan.
If you have a standard amortizing loan, that means you’re making equal monthly payments. Those payments in this scenario go toward the interest and principal. Over time the amount that’s going toward your principal goes up. Each year that you own your home and pay your mortgage means you’re gradually paying it off faster.
You can also grow your equity by working to increase the value of your home. Home prices do tend to rise in a healthy economy on their own as long as the real estate market is doing well, and you can speed that up based on the work you do to your home.
You can also make accelerated payments on your mortgage. Most of the time as a homeowner, you’ll make 12 payments a year. If you split a payment into two equal amounts and send it every two weeks, you end up making 26 payments a year. That ends up being the same as having paid 13 monthly payments, so you’re taking some interest off the total life of your loan.
You’ll be able to pay your mortgage faster and build equity more quickly too.
Using Home Equity
The equity you have in your home is an important asset, and it’s calculated as part of your net worth. You can use your equity in different ways.
If you sell your home, then you’re taking the equity you have in your home from the sale.
You can also get a loan against your equity. This is known as a home equity loan or second mortgage.
Overall, having a mortgage is sometimes viewed as forced savings. Each month that you’re making a payment or perhaps multiple payments, you’re building equity or building the value of an asset. It’s like adding money to a savings account but instead of your asset being cash, it’s your home’s equity.