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Building home equity is important because it adds to your net worth, gradually converting your debt into assets. Homeowners with high equity benefit from more resilience to adverse real estate market conditions, such as a sudden decline in property values.
By making your monthly mortgage payments, you can grow home equity and then sit on it, allowing it to act as a stabilizing, foundational investment. Once you build sufficient equity, you can leverage the wealth tucked away in your home to borrow against it, helping you access flexible, low-interest financing. Here's a guide to building home equity and why it matters.
What Is Home Equity?
Home equity is the portion of your home you own free and clear. In other words, equity is the difference between your home's value and the balance you owe on your mortgage.
One of the principal benefits of homeownership is that it immediately opens the door to equity building through paying your mortgage and benefiting from market increases:
- Mortgage payments: Each month, your mortgage payment goes toward paying off interest and reducing your principal balance. As you shrink your balance over time, your home equity increases.
- Home appreciation: While market conditions could always swing in the other direction, in general, property values increase over time. Homeowners who stay put for several years often see equity blossom beyond the cash they've put into property upkeep and mortgage payments.
Why Is Home Equity Important?
Home equity is an asset that increases your net worth and boosts your financial health. You can think of your mortgage payments as a type of monthly savings deposit, akin to investing in a long-term asset such as bonds. Your money is tied up for now, but it's there when you need it.
Someone with a loan-to-value ratio (LTV) of 50% or less is considered equity rich. Having high equity tucked away in your home is a good position to be in for a number of reasons. Most simply, if you sell your home, having greater equity means walking away with higher proceeds from the sale. For example, if you sell a home for $500,000 and you owe $250,000 on the mortgage, you'll walk away with $250,000 in cash (minus selling costs).
On the other end of the equity spectrum, it's possible to have negative equity, also known as being underwater on your mortgage. Having negative equity means that you owe more on your mortgage than your home is worth. This isn't a good position to be in for a number of reasons and can make selling or refinancing your home more difficult.
How to Calculate Your Home Equity
The trickiest part of calculating your home equity can be determining your home's current fair market value. You may be able to come up with a rough estimate by looking at recent sales in your neighborhood, but finding comparable properties can be a challenge. A property's value is largely impacted by condition, size, modern aesthetic updates, appliances and renovations.
For an accurate figure, your best bet is to contract a real estate agent for a comparative market analysis or hire an appraiser to assess the fair market value of your home.
Once you know your home's value, calculating how much equity you have in your home is simple:
Home Equity = Market Value of Home - Amount Owed on Home
For example: Daniela has $160,000 left on her mortgage. Her home's appraised value is $370,000. She plugs these numbers into the home equity formula:
Home Equity = $370,000 - $160,000
After crunching the numbers, Daniela is pleased to learn she has $210,000 in equity.
How to Build Home Equity
Building equity takes time. Some experts suggest that homeowners should stay put for at least five years before selling in order to ensure they build enough equity to avoid losing money when they sell.
- Make extra mortgage payments. Paying additional money on your mortgage, such as an extra $100 or more each month, can help you build equity faster. Be sure to find out how your lender handles early mortgage payoff to avoid any fees.
- Refinance to a shorter term. Refinancing your mortgage to a shorter term, such as a 15-year mortgage, can increase your monthly payments and decrease your interest rate. That means you'll make larger payments to pay down your loan quicker, and more of your payments will be applied to your principal as you accrue less interest.
- Complete projects with good returns. Investing in home renovations and repairs can add value—plus personal enjoyment—to your home. Be sure to research a project's return on investment (ROI) to learn how much of the cash you sink into a project you can expect to recoup.
Downsides of Tapping Into Home Equity
But before you tap into equity, keep these considerations in mind:
- Lenders typically won't allow you to tap into your home's full equity. Most limit what you can borrow to keep at least 15% to 20% equity in your home. If you do qualify for a home equity loan, there are also often minimum borrowing requirements.
- Tapping into home equity is essentially converting your assets back into debt, which carries risk and reduces your net worth.
- A borrowing product such as a home equity loan or home equity line of credit (HELOC) adds an extra monthly payment to your plate.
- A home equity loan, HELOC or cash-out refinance often requires you to pay closing costs.
- Using a cash-out refinance, home equity loan or HELOC to tap into equity is using your home as collateral for a loan. If you're unable to afford your payments, you could lose your home in foreclosure. Missing payments can also hurt your credit score.
Ways You Can Use Home Equity
Home equity can be an excellent resource for homeowners to borrow money for home improvements, debt consolidation or other expenses. Generally speaking, the best ways to use home equity are those that increase your financial stability:
- Renovate your home. Equity can be a good way to finance a home renovation, especially when the project will put more equity back into the house.
- Buy real estate. Buying an additional home with an equity loan can help you access low interest, afford a large down payment and, if you buy a commercial or multifamily investment property, generate income and build more equity still. While investing in real estate can be risky, and could put you in a position to pay two mortgages at once, over time it can be a solid investment.
- Refinance higher-interest debt. If you're carrying balances on your credit cards or managing multiple high-interest loan payments each month, consolidating your balances with a second mortgage or refinance could help you save interest while you pay off debt.
- Cover emergency expenses. Borrowing from home equity can provide access to low interest when you need cash for an urgent expense, such as a car repair or medical bill. Ideally, aim to avoid relying on borrowing in a pinch by building an emergency fund.
The Bottom Line
As long as you diligently weigh your options and ensure you're in a financial position to manage new payments, borrowing against your home equity can be a smart way to fund goals such as renovating your home or paying off debt. Even if you don't plan to sell your home or tap into equity any time soon, simply building financial stability is a huge win.
Before you consider lending options, check your credit score for free through Experian. You'll see where your credit score stands now, plus have access to insights on how your score may impact the rates you qualify for and how to improve your credit.