One of the primary goals of homeownership should be the building of equity in the home. Equity is simply the difference between the current value of a property and the balance of all mortgage obligations. For example, if you have a home that is valued at $175,000 (based on an appraisal or a Comparative Market Analysis
— a CMA, not on an “I wish” number) and a mortgage balance of $147,000, you have $28,000 in equity ($175,000 minus $147,000 = $28,000). That $28,000, as long as the market remains stable, is like money in the bank. As values increase and mortgage payments reduce the level of debt, the equity—that “money in the bank”—grows also.
We’ve seen a strange phenomenon in the last few years when it comes to the level of home equity that people have in their homes. Home prices have appreciated at an almost unprecedented level, meaning individual homes are worth more (and some are worth a great deal more). Mortgage interest rates, on the other hand, are at historic lows, meaning that less of each monthly payment is going to interest and more is going to principal, lowering balances quicker. More value and less balance equate to more equity in the average home, right? Actually, the exact opposite is true.
While values of homes are growing at exceptional rates, so too are loans taken against that value. The home equity loan (and credit line) business is booming. More and more people are using the equity in their homes to finance home improvements, purchases, even pay off outstanding credit card debt. Thus, home equity levels are at one of the lowest levels in history. Instead of having more money in that “bank account” we have less. Instead of building wealth, we are eroding it.
Why is equity in a home important?
Simply stated, the appreciation of equity in a home is one of the easiest and most successful paths to wealth that is available to you. To a large degree, it is almost painless—you make the mortgage payment that you would have to make anyhow and the balance is reduced. The value of the home, meanwhile, is rising. Every month, then, your nest-egg should be growing. The quicker you find yourself at 100% equity—owning nothing on your home—the quicker the route to a comfortable (or early) retirement, to less financial stress, to true (as opposed to fake) wealth.
Four ways to build additional equity in your home
There are a number of ways to build additional equity in a home, some easier than others but all effective. Four simple ways to build equity in your home are
- Higher initial down-payment
- Extra principal payments
- Shorter mortgage term
- Home improvements
Here are the four ways expanded with more details.
1) Higher initial down-payment
One of the most common mortgage mistakes is not putting down a large enough down payment. The most obvious way to build additional equity is at the first opportunity—making a larger down-payment at the time of purchase. This extra money is immediately “banked” in the home, making it much less tempting to spend.
2) Extra principal payments
Making extra payments of principal (or just adding money to your monthly payment designated to go to the principal) has a double effect on your equity. First, every dollar you send reduces your debt by the same amount. Second, reduced debt means less interest paid, which means that each month more of your payment goes to principal and less goes to interest. NOTE: Although most loans allow it, be certain that your lender will accept extra payments of principal.
3) Shorter mortgage term
The lower mortgage interest rates that we have seen recently means that for many buyers, they are able to either initially secure a mortgage with a shorter term or, if they are currently in a long term mortgage (such as 30 years) refinance and get a shorter term. These shorter mortgage terms mean that you will be paying down your principal much quicker and therefore gaining additional equity at a much faster rate.
When you improve the quality or size of your home, you also increase its value and thus your equity. Be aware, though, that although virtually all home improvement projects will bring some return, some are much more advantageous than others. For example, remodeling kitchens or renovating bathrooms traditionally have brought a greater return than adding leisure amenities such as pools or whirlpools. To get the maximum equity enhancement, make certain that the kind of improvements you are looking to do will raise the value appreciably.