Everyone understands debt. Whether it’s healthy or unhealthy debt, it’s always cast as the villain in your financial movie. Relatively fewer people understand the concept of equity, and to say that equity is the exact opposite of debt would be rather loose-handed. Instead, let’s think of equity as what you ‘own’ and debt as what you ‘owe.’
This distinction is especially crucial for home sellers. A mortgage is usually characterized as a healthy debt, and the reason it’s considered healthy is that it helps you build home equity. It is your stake in your unpaid house, or the part of the house you actually own, while the other part is tied up with your mortgage.
When you take out a $200,000 mortgage on your $250,000 house and pay $50,000 in the down payment, your financial stake in the house is $50,000. While the remaining $200,000 is the bank’s (lender’s) interest in your property.
Your lender’s stake in the house is purely financial, i.e., your unpaid mortgage. You legally own the home as a property. You can remodel it, renovate it, or raze it to the ground to build a new one, and your lender won’t have any problems unless you default on your mortgage.
How much of the house you own is your home equity. It’s a financial asset that you can employ in tough economic times, for significant home remodeling and even for investing.
So how do you build equity? Here are five ways you can go about it.
Larger Down Payment
A larger down payment is the simplest and most basic way to increase your home equity. Crudely put, down payment is the part of the home equity that you are buying outright. The recommended amount of down payment for any house is 20%. But more than two-thirds of total home buyers pay much less than that. This incurs an extra expense of Private Mortgage Insurance.
The more your down payment is, the more your financial stake in the house is, right from the beginning. Additionally, a sizeable down payment will help you secure more favorable mortgage rates, so you will be able to pay off the rest of your debt quickly, thereby increasing your home equity.
Wait for Value Appreciation
Value appreciation is the most significant factor in improving your home equity, and frustratingly the one you can do very little about. The more your house appreciates in value, the more your home equity builds. Because the amount you owe in your mortgage will remain the same.
Let’s say that your $250,000 house increases in value, and is worth $300,000 in just two years after you bought it. We are assuming you have a 30-year mortgage with a 5% interest rate. In two years, you have paid around $26,000 (rounded off from $25,752) in the mortgage. So by now, you have paid a total of $76,000 for your house, and you still have about $194,000 balance payment left.
Home equity is simply calculated by subtracting your home’s value by the amount you owe. So your home equity is $106,000 ($300,000 – $194,000). Even though you have only paid $76,000 towards your house yet. This is the power of value appreciation.
The calculation above is made without considering the taxes and insurance, but it should give you a good idea of how your home equity grows alongside appreciation.
Lessen your Mortgage Years
Your home equity increases in proportion to your mortgage payment. The more and faster you pay your mortgage, the higher your home equity will get. If you refinance your mortgage from a 30-year plan to 20 or 15 years, your home equity will start to build much faster.
People don’t often consider this option because they think that converting a 30-year mortgage to a 15-year one will double their mortgage payment. That’s not true at all. Your mortgage payment will increase significantly, but it won’t double in amount. If you are paying $1,073 monthly towards the principal and interest of your 30-year mortgage, you will pay $1,581 for a 15-year mortgage.
It’s far from double, but it will build your home equity much faster.
Pay More Now to Pay Less Later
Even if you don’t go for a complete refinancing, you can make some other contributions to pay off your mortgage early. Let’s say you got a bonus, or a piece of inheritance, you can direct that extra cash towards your mortgage. A few contributions like these applied towards your principal sum will significantly boost your home equity.
Another way to do it is by increasing your monthly payments and requesting that the extra amount be applied towards your principal sum. It will also help you build equity, and a reassessment of your mortgage might even get you favorably adjusted rates.
Some people find it useful to make bi-monthly payments. If you pay every two weeks, you will be making a total of 26 payments a year or 13 payments equal to your monthly amount. So you will be paying an extra month’s mortgage each year without straining your budget too much. It will also help you speed up your mortgage payment, boosting your home equity faster.
Unlike value appreciation of the market, which you can’t contribute to, remodeling and renovating is something you can do to add value to your home. But you have to pick and choose what to renovate and refurbish to increase the value of your property. If you are investing much more than you will get in returns than that value, appreciation is useless to your home equity.
You can use this calculator to run your own numbers.
Building your home equity is a brilliant way to make yourself a better financial future. Mortgage seems like a hard road because many people disregard home equity, and feel like they only genuinely own their home when it’s all paid off. But if you understand the value of home equity, you know it’s helping you build your asset.
There are several ways you can leverage your home equity to take care of significant financial problems. This is why it is important that you have enough of it built up as soon as possible.