Home equity, to put it simply, can be one of your biggest assets as a homeowner. It builds over time as you make monthly mortgage payments — and you can use this equity in your home to your advantage. Therefore, it’s important to understand the basics of how home equity works and how it can help you.
Home equity, by definition
It’s the difference between the property’s current market value and the amount you still owe on the mortgage for that property.
Let’s say your home is currently valued at $350,000 and you owe $125,000 on the mortgage — the amount of equity you’ve built up is $225,000.
Building home equity
How does equity work, and how can you increase it? Here are three of the biggest ways:
Loan repayment: As you make mortgage payments and pay down your principal, your equity increases. You can also make larger monthly mortgage payments, pay more towards your principal, or make biweekly payments to build home equity quicker.
This is one of the biggest benefits of owning a home versus renting one. The money you’re paying isn’t going into a landlord’s pocket. It’s goes toward your investment, and you can make it work for you.
Home price appreciation: Here’s a way to build equity without having to do a thing. Your home can gain value if home prices rise and, therefore, your equity increases with your home’s new market value.
Let’s say you bought your house for $200,000, put down $25,000 upfront, and borrowed $175,000. Five years later you’ve made every monthly payment and have paid down $50,000. Now you owe $125,000, but during that time, your home’s value has increased to $250,000. Your equity $125,000.
Home improvements: Certain home improvement projects where the value exceeds the cost can help you build equity. Simply put, you’ll have a house that’s worth more than what it was before these additions.
Using home equity
As we mentioned before, home equity is a huge asset that can really work for you. But how?
Buy your next home: If you’re already a homeowner who plans to sell your home at some point, you can put your earnings from the sale price toward the purchase of your next home. However, if you haven’t paid off the mortgage yet before you sell it, you won’t get to use all the earnings from the buyer, but you’ll get to use the equity (as seen in the example above).
Refinancing with a return: A cash-out refinance gives you access to your home’s equity by refinancing your existing mortgage into a new one with a larger principal, but you pocket the difference in a lump sum.
If the amount of equity you’ve built up is $125,000 on a $200,000 loan, and you need $50,000, your new mortgage amount will be based on the total amount you owe ($75,000) plus the cash you receive, or $125,000. Typically, your lender will limit the cash-out amount to 80% of the home’s value.
Many homeowners use the cash to pay for major expenses, such as: high-interest credit card debt, college tuition, and home improvements/renovations.
Who knew such a simple term could be such an important asset for your future? Speaking of terms to know, you should wrap your head around these, too: The 13 Mortgage Terms You Need to Know (That Many People Don’t).