What is Home Equity?
Home Equity Defined
In basic terms, home equity is the amount of financial value that a homeowner has built up in their home. To discover how much home equity you have, take your property’s market value and subtract your outstanding loan balance. As you pay off your mortgage (or your home’s value increases), the amount of home equity you have increases.
For example, if you purchase a $300,000 home (with an equivalent market value) with a 20% down payment, you would be getting a loan for $240,000. The moment you purchase it, your home equity is only the $60,000 down payment you made. However, if you paid off another $20,000 in principal, or the home’s value goes up to $320,000, you’d now have a home equity of $80,000.
In many cases, your home equity could be the most valuable asset you own. If you build it up, you can use it to help pay for some of life’s expenses via a home equity loan (HEL) or a home equity line of credit (HELOC).
How can you build more equity in your home?
Most standard mortgages are amortizing loans. This means that you pay off both the interest and principal at the same time. So, as time goes on, you’ll slowly build more equity in your home as the parts of your mortgage payment that go to the principal add up over time. However, if you have an interest-only loan, you’ll only be paying interest on the loan (not the principal) for a specific period, often the first 5-10 years of the loan.
While interest-only loans can help you buy a more expensive property and allow you to put off larger payments until later (when you might have a higher level of income), they don’t allow you to build up equity in your home during the interest-only period.
Plus, interest-only loans can be significantly more risky than their traditional counterparts. If your home’s value decreases significantly, you may wind up owing more on your home than you can sell it for. That’s often referred to as being upside down or underwater-- and, much like the guests on the Titanic, it’s not a situation that anyone wants to be in.
So, instead of taking on a riskier, interest-only loan, you might want to stick with a regular mortgage and make extra payments. That way, you’re building more home equity, your mortgage will get paid off faster, and, in the end, you could save significant cash. Woohoo!
What’s the best way to build home equity?
While paying off your mortgage (early, if possible) is a great idea, there’s one other thing you can do to start out with a lot of home equity: buy a home that’s priced significantly under its market value. While that can be a challenge, some sellers need to move quickly and may be willing to make a relatively fast sale for a price well under a home’s appraised market value.
In other cases, you may be able to find a low-priced home at a distressed property auction or a foreclosed property auction. While this may offer some incredible deals, it’s important to be aware of the risks: distressed properties may have structural problems or need unexpected prepares. Plus, a distressed or foreclosed property may be more likely to have a lien against it or another title issue that could come as a nasty surprise.