You might consider yourself a homeowner, but more than likely you don’t own your home free and clear. It’s most common for homebuyers to need the help of a mortgage loan to purchase a property.
Home equity is the balance of your mortgage (the loan used to buy the property) subtracted from the current market value of the home. For example, if you still owe $300,000 toward mortgage payments but the home is worth $400,000, that difference of $100,000 is your equity. To put it simply, the equity is the portion of your property that you truly own without including the lender’s interest.
Each month when you make regular mortgage payments, a portion of your payment goes toward the interest charge from the lender and a portion goes toward paying down the balance of your loan, which is known as the principal. As the balance of your loan decreases, your equity increases.
Even though your lender doesn’t actually own any portion of the property, the house is being used as collateral for your loan. Your lender has secured their interest with a lien against the property to insures that you will pay the monthly mortgage bill. Once you have paid off the entire mortgage, the property in its entirety will become yours.
There are two ways to gain equity on the home you own. The first is by paying down the principal balance of the mortgage. Having a smaller loan will mean owing less to the bank and owning more of the property yourself.
The second way to gain equity is an increase in market value. To revisit the earlier example of a $400,000 home, having a mortgage of $300,000 on a home that has appreciated in value and is now worth $500,000 will leave you with $200,000 in equity. As similar homes in the area sell for more money, these comparable sales will set the new standard of fair market value of the surrounding homes. In popular neighborhoods, the prices may increase significantly in just a few years.
A healthy real estate market will increase in value annually. Home renovations can help increase the value of the property too, but it is important to keep in mind that the cost of the renovations isn’t necessarily equal to the benefit. Spending $40,000 on a new kitchen may not mean that the home is worth an additional $40,000. The best way to find out the fair market value of your property is to have it professionally appraised. Smart improvements can positively affect the appraisal price. To help you decide what improvements to make, look at the surrounding homes, particularly on the same street or block. If none of the neighboring homes have upgraded kitchens, then shelling out top dollar for Italian marble countertops will have little to no return. Consequently, if a luxury kitchen is standard in your area, then you will need to keep up with the Joneses in order to qualify for a valuable appraisal. If you are planning to sell your home, I recommend staying away from any major cosmetic upgrades but instead focusing on repair items like repairing wood rot or termite damage.
Equity is considered an asset and counts toward your total net worth. Having equity in a property is beneficial if you decide to sell the home and make a profit, but there are other options to use the equity to your advantage as well. Home equity can be cashed out in a loan refinance or can be borrowed against as collateral for a home equity line of credit (HELOC), which is a type of loan secured against the property making the interest rates lower than a credit card. Some homeowners will use the equity in their property to renovate the house or even to buy a second home or income property.
Building equity is the major upside of owning a home versus renting, where paying a landlord actually contributes to building someone else’s equity. Equity reveals the portion of the property value that you can rightfully claim as your own. If you are planning to sell your home, the higher the equity amount, the more cash you will get out of the sale. For most, the equity built up in a home is the largest financial asset and an incredible way to build wealth.