Equity is a valuable asset. When a property owner has it, they can use that asset as security in various ways, such as obtaining a low-interest loan when they need it. To have equity, an owner has to work to build it – which generally means paying off the debt on their home or adding value to their property.
- 1 What Is Equity?
- 2 What Is the Value of Equity?
- 3 How to Build Equity
What Is Equity?
Equity refers to the unmortgaged value of a property. For example, if a property is valued at $250,000, but the owner has a mortgage with a balance of $200,000, they have about $50,000 worth of equity. In most mortgages, equity builds with each payment. However, mortgage payments also include interest payments. That means each of the payments made is divided into principal (which builds equity) and interest payments. The amount of each depends on the stage of the loan and the terms of the mortgage.
To determine the equity in a loan, obtain the current value of the home. For the most accurate results, owners must utilize an appraisal of the home to determine the current market value. Once the value is determined, subtract away any outstanding balance on a loan. The remainder is the equity in the property.
It is possible to have negative equity. This can happen if the property’s value drops after the home is purchased. If the value of the property drops at a faster rate than the mortgage is paid down, that can create negative equity or upside-down mortgage.
What Is the Value of Equity?
Equity offers property owners numerous benefits. The most important is freeing up the value of an asset to borrow against later if necessary. For example, if a person needs to borrow money to consolidate debt or wishes to add an extension onto the home, many lenders will provide an equity loan. The loan uses the home’s value to secure it. As such, there is less risk to the lender. That leads to the lender offering a substantially lower interest rate on the funds.
If a property owner sells a home with equity, he or she could receive cash after the sale. For example, if a home sells for $250,000, and the borrower owes just $100,000 on the existing loan on the home, they would receive $150,000 cash, or around that figure.
Sometimes, people with equity can use the value of their property as a down payment on their next home purchase. This can be done by taking a loan out on those funds or selling the home, collecting the equity, and then purchasing a new home. Some people can use this equity to buy a second home, too.
How to Build Equity
Equity is valuable. It provides several benefits to property owners who have it. Yet, to get there, the owner has to know how to build equity. There are two ways to do this. The first is paying down the existing balance on the mortgage loan. Paying down the debt frees up equity. On the other hand, owners can also add more value to the property. That boosts the value of the home, increasing equity.
There are many ways to accomplish either option. Here are some key examples of ways a property owner can increase the equity in their property.
Make a Large Down Payment at the Time of Purchase
The fastest way to have equity in a home is simply to put in a large down payment on it. A home buyer will reduce his or her debt from the start using this method. It is one of the best ways for a home buyer to create equity right away. It is unlikely that most people will buy a home that is valued significantly higher than their purchase price. That is why a big down payment can be beneficial.
There is another key benefit to making a large down payment like this. Many times, down payments like this, reduce the risk to a lender. As a result, they may offer a lower interest rate or better terms for the buyer if a down payment is made. This can significantly reduce financial obligations later and lowers the overall cost of purchasing a home.
Standard down payments are now about 20 percent of the sale price of the home. It may be possible to put in less depending on the type of loan secured. Yet, a big down payment offers these benefits.
Pay Extra Each Payment on a Mortgage
Another way to reduce debt and increase a home’s equity value is to pay more on the mortgage loan each month. It is important to ensure the lender applies the extra payment directly to the principal owed on the loan. It should not be applied to the interest portion of the loan. Paying down the principal faster builds equity but it also reduces the amount of time interest has to build against the loan’s value. That can help to save a borrower funds over the lifetime of their loan in lower interest costs.
Here is an example. If the borrower makes an extra $200 payment on their loan each month, that means that, over the year, they are adding as much as $2400 in equity to their property. The owner can choose how much of a monthly extra payment to make. There is no limit here in most cases. Ensure the loan funds are going directly to pay off the principal to make it count.
Add Home Improvements to the Home
Another key way to build equity is to add value to the home. Homeowners can do that by making home improvements to the space. While maintenance is one key way to keep the value high, home improvements add features and elements that make it even better. There are various ways this can work, but generally speaking, a significant home improvement is necessary to add real equity to the property. It also has to be something the adds value that other buyers of the home can recognize, not just upgrades that the property owner will benefit from.
There are many potential ways to achieve this. For example, updating the kitchen to a more modern design, especially if it is older, is one way to do so. Another may be to add more bedrooms or bathrooms to the floor plan. It may be possible to make improvements to equity by adding better landscaping features. This may include an outdoor kitchen area or outbuildings.
Homeowners need to make wise decisions here. Not all investments will offer the same benefit. Some home improvements add more value than others do, such as updating the kitchen or finishing the basement. However, this is not often one-for-one. For example, spending $20,000 up to modernize the basement may not lead to a $20,000 increase in the property’s value. Finding a balance here is best.
Make Additional Payments Each Year
Another way to increase the equity in the home is to simply make additional payments over and beyond the payments required on the loan. It is important to ensure these added payments go directly to the equity in the property and are not applied to the interest portion of the loan.
For those who have a 30-year mortgage, adding extra payments directly leads to a reduction in the length of time the loan will remain in place. It also reduces the amount of interest that will be paid on the home over its lifetime. That amount also builds equity. For example, if a homeowner makes an extra $1000 payment on their home loan, and has those funds applied to the principal owed, it adds value.
There is an easy way to do this. Instead of making one payment every month on a loan, make half of a payment every two weeks. Because there are 52 weeks in a year, homeowners will make a total of 26 half-payments, or 13 full payments instead of the standard once a month payments. That means that, without feeling the pinch of the cost, the homeowner will be making a full extra payment on the loan, adding to the equity and reducing the overall cost of the loan. Most lenders allow homeowners to set up bi-monthly payments like this. Again, it is important to ensure the funds are going directly to the principal of the loan.
Put other payments throughout the year towards the loan as well. For example, property owners may receive a bonus mid-year. They may receive a tax refund each year. Putting those funds into the home loan will raise equity for the property owner without losing those funds. If down the road, they need to tap into these funds, they can do so through a low-interest loan. This can be a very affordable way of paying down the loan.
Refinance to Shorter Terms
Equity is built with each payment a person makes on their mortgage loan. However, the amount of principal paid in a loan is directly related to the length of that loan. Shorter loan terms can help a property owner to pay down the debt faster then, which in turn increases the speed of building equity.
By moving into a shorter-term loan, for example, instead of a 30-year loan term, consider a 15-year loan term, there is less time for the interest to pile up. That saves the owner money. It also means that the monthly payment for the loan will be significantly higher. If the property owner can afford this, it can reduce the overall cost of the loan significantly.
When a shorter term is secured with a lower interest rate, the benefits are even more numerous. In this situation, the property owner is likely to pay less in interest overall and have a more affordable monthly payment. In many cases, this can reduce the overall total cost of purchasing a loan significantly.
Use an amortization calculator to shed more light on the options that apply in your situation in these loans. Many property owners will find this is a good way to see the difference in making additional payments and having lower terms or interest rates.
Wait for Market Values to Increase
In some markets, homes increase in value over time without the property owner doing anything to make that happen. This differs from one area to the next. In areas with a strong demand for housing, home values will likely rise faster than in other areas. While this is not the most reliable way to improve the equity in a home, it is likely to add some value over the lifetime of the loan.
To learn the current value of a home, property owners need to have a formal appraisal conducted. A real estate agent can also offer some help with a comparative market analysis that looks at the current pricing in the area – how much home buyers are spending to buy property in the area – and determines the likely value of the owner’s home.
Maintain the Upkeep of a Home
One way to build equity is to ensure nothing is holding the property from increasing in value. For example, if routine maintenance is not occurring, that can reduce the value of the home over time. This includes routine cleaning, but it also includes maintaining windows, roofing, siding, and other structural components. In these situations, the goal is to simply maintain the condition of the home and work to keep it modern. This reduces the risk of losing money over time.
Building equity is like creating a forced savings account. It allows a homeowner to have a significant amount of money put away to meet their needs if they need to do so later through a low-cost loan. Yet, even if a homeowner does not need to use these funds, there is still value in having equity in the property when it comes time to sell it down the road.