If you’re a homeowner, those mortgage payments you’re making every month can help you build a powerful asset: home equity. Home equity represents the amount of your home that you own (free and clear from financing), and it can grow over time.
Building home equity is an important part of homeownership because it’s a resource you can convert to cash when an expense arises. You can draw from the equity using a home equity loan or home equity line of credit (HELOC) or wait to cash in the equity when you sell the home.
What is equity?
Your home equity is the portion of your home that you own, calculated by subtracting your mortgage balance from the home’s market value.
Say your home is worth $250,000 and you owe $150,000 on your mortgage. To get your home equity, you would make the following calculation:
$250,000 − $150,000 = $100,000
If you’re looking to take out a home equity loan or line of credit, it’s good to know how much equity you have because lenders set borrowing amounts based on the amount of equity you own. Generally, the more equity you have, the more money you can borrow. Knowing how to build equity helps you create a meaningful asset over time.
Why building equity in your home is important
Building home equity is important for a few reasons. It can not only be a reliable way to build wealth, but also help you maintain the home while you’re in it.
Building equity in a property means:
- You can borrow equity for nearly any purpose. Homeowners can borrow against the value of their homes through home equity loans and HELOCs. With a loan, you receive all funds at once and immediately start paying them back over a period lasting up to 30 years. When you take out a line of credit, you have a draw period (often up to 10 years) when you can withdraw what you need when you need it and make interest-only payments. You then have a repayment period (typically 10 to 20 years) when you pay back both interest and principal.
- You will make a profit when you sell the home. You don’t want to find yourself “upside down” in a home, owing more on the property than you can recover in a sale. When this happens, the only way to sell is by getting your bank to agree to a short sale. Building equity means you will sell the property for more than you owe. You can use the profits for another home, pay off other debt, or invest it elsewhere.
- You can build long-term wealth. Building home equity can help you increase your wealth over time, especially if you purchased your home when the market was in buyers’ favor. A home is one of the only assets that has the potential to appreciate in value as you pay it down.
How to build equity in your home
To build home equity, you can either increase your property value or decrease your mortgage debt. Below are a few options.
Make a big down payment
Your down payment kick-starts the equity you build over time. Depending on your mortgage options, you could put down as little as 3 percent or even 0 percent when you close on the home — but putting down more will instantly boost your equity. And if you can put down at least 20 percent, you’ll also avoid paying private mortgage insurance, or PMI.
When figuring your down payment, though, you should consider how much savings you’ll have left after closing. If you’re left with little to no cash reserves, then it may be harder to handle financial emergencies or your regular monthly payment.
Increase the property value
Making key home improvements can boost your home’s value, and therefore your equity. Just keep in mind that you likely won’t recoup all the money you put into your home projects. According to Remodeling Magazine’s 2021 Cost vs. Value report, the average upscale bathroom remodel provides a 54.8 percent return on investment, and the average minor kitchen remodel with midrange finishes provides a 72.2 percent return on investment.
Before taking on your next remodel, consult with a real estate agent or other home professional to see which types of renovations get the most return. You should also consider how much the home improvement project will contribute to your experience while living in the home. According to a National Association of Realtors report, 74 percent of homeowners had a greater desire to be in their homes after completing remodeling projects.
Pay more on your mortgage
Most mortgages are on an amortization schedule, meaning you make payments in equal installments over a set period of time until the loan is paid off. While you’ll always pay both principal and interest, a larger portion of the payment goes toward interest in the beginning, and over time more goes toward the principal.
However, if you make extra payments toward the principal every month, you build equity quicker by decreasing the overall total you owe. If you have the means to pay a little extra, call your loan servicer and ask how it’s done, and then follow their instructions. Check your monthly statements to make sure the extra money is put toward the principal. Here are a few ways to pay your mortgage off faster:
- Switch to biweekly mortgage payments. Split your mortgage payment in half and send each half every two weeks instead of once at the end of the month. This adds one extra payment to your mortgage every year, which can ultimately shorten your loan term and save you money on interest.
- Add a certain amount each month. Check your budget to see how much extra you can realistically put toward your mortgage every month. For example, if you just paid off your car loan, consider putting that extra $250 toward the mortgage every month.
- Use occasional extra money. Any time you receive a tax refund, a bonus at work or a cash gift, put it toward your mortgage balance.
Refinance to a shorter loan term
A shorter loan term has two main benefits: You typically get a lower interest rate, and more of your mortgage payment goes toward the principal each month. Choosing a 15-year mortgage from the start helps you build more equity every month than you would with a 30-year mortgage. If you already have a mortgage, you can refinance into a shorter-term loan.
However, there’s a catch: Payments are higher on a shorter loan term. Make sure there’s room in your budget for that larger mortgage payment before you refinance.
Wait for your home value to rise
Local housing markets change over time, so your home value may fluctuate. When home prices increase in your neighborhood and demand grows, the value of your home naturally rises. This appreciation in home value boosts the amount of equity you have. Conversely, when home prices drop, you may lose some equity.
While you don’t have much control over this factor, it’s good to keep in mind. You can check your home’s value using an online home price estimator such as Zillow’s Zestimate or Redfin’s Estimate or by consulting a professional appraiser.
The bottom line
Building equity may take some time, but it’s worth it; once you have enough equity, you can draw from your asset using a home equity loan or home equity line of credit. Making a large down payment, boosting your property value and paying more toward your mortgage every month are just a few ways to grow your equity.