What is Equity?
Equity is the amount of your home that you actually own. If you borrow money to buy your home, you can calculate equity by subtracting your loan balance from the value of your home. If the result is a negative number, you have negative equity and you still owe payments on your home. This is the main idea of the rent vs. buy debate. Even if you still owe on your mortgage, at least the payments are slowly adding to your equity. When you pay rent to your landlord, that money solely goes in their pockets.
Example: Your home is worth $350,000, and you owe $200,000 on your mortgage. $350,000 minus $200,000 equals $150,000 of equity in your home. What can you do with your equity? You can:
How to Build Equity
The more equity you have, the better. There are two ways to build equity, its simple:
- The property value increases
- The amount of debt decreases
You can take an active or passive approach to build equity, depending on your goals, your resources, and your luck.
Increase the Property Value
Your home’s market value is an important element in your equity calculation. If the home’s value rises, you instantly have more equity. So what makes home prices head upward?
Rising prices in your market: If you’re fortunate, home values in your market might increase over time without any effort on your part. This is most likely to happen in attractive neighborhoods and growing towns.
Home improvements: You can also invest in your home to increase its value. Updating kitchens and bathrooms, improving landscaping, and making the home more energy-efficient can all pay off. But
those projects cost money up front, and you need to be confident that you can more than recoup those costs. If you’re making improvements mainly to build equity, pick projects with the highest return on investment (ROI).
Upkeep: Routine maintenance is boring, but a home that’s falling apart is not worth much to anybody. You can actually see your home equity decrease if you fail to address issues like leaks and deteriorating roofing.
Reduce the Debt
Monthly payments: With most home loans, you pay down your loan balance a little bit with each monthly payment. A basic amortization table can show you the process in action. The longer you have your loan, the more principal you pay (more of each payment goes towards equity, and less of each payment evaporates in interest charges). It’s actually pretty easy if you just keep making payments—you build momentum, making increasingly large principal payments without even trying.
That’s the passive approach to eliminating debt. But you might want to accelerate the process and build equity more quickly. There are several ways to do that.
Choose shorter terms: Shorter loan terms cause you to pay down debt and build up equity more quickly than long-term loans. For example, a 15-year mortgage would be better than a 30-year mortgage if your primary goal is to build equity. As a bonus, those shorter-term loans often come with lower interest rates—that, combined with the fact that you’re paying interest for fewer years, means you’ll actually spend less on interest over the life of your loan.
Make extra payments:
Even if you have a 30-year mortgage, you can speed things up by paying extra. Each extra dollar you pay above and beyond your required payment reduces your debt and goes towards your equity—just make sure your lender applies those payments to the principal. Nothing is stopping you from setting up a 15-year repayment schedule (see the link to the amortization table above) and making those bigger payments on your 30-year loan. If things change at some point and you can’t afford to do that anymore, you’ve got the flexibility to go back to the smaller 30-year payment.
If that’s too complicated, just send an extra payment from time to time.
Leave it alone: Second mortgages and refinancing can interfere with debt reduction. Obviously, if you can save a bundle by refinancing, go ahead and do it. But remember that with most loans, you pay mostly interest in the early years of your loan. Every time you start over, you delay (or at least slow down) your equity-building. Borrowing against your home with a second mortgage or HELOC increases your debt and reduces your equity.
Sometimes people refer to a mortgage payment as “forced savings.” You might not think you’re saving any money by making payments each month, but you are building up the value of an asset (like you would build up the value of a savings account by making regular deposits). With a home, the asset isn’t cash in a savings account—it’s equity in your home.