Equity is a word home owners and buyers often hear, but what does it really mean?
In accounting, it is the difference between the value of the asset and the value of the liabilities or debts against the asset. If we apply that to real estate, equity is the difference between the property’s current fair market value and the amount the owner still owes on the mortgage. Equity then is the value of your property minus outstanding debts, liabilities and other obligations.
Why Equity Matters
Equity matters because it represents the real value of your stake in an investment. In the case of real estate, you can think of home equity as comparable to home ownership. The amount of equity you have in your house represents how much of your home you actually own. It comes from payments made against a mortgage, including your down payment and from increases in property value (a.k.a. appreciation). It is also usually a person’s biggest source of collateral and can be used to get a home equity loan or a home equity line of credit.
Clearly, equity is a good thing, but how does one increase it?
As you pay down your loan balance, your equity increases. While that sounds simple, it both is and isn’t. The majority of home loans are standard amortizing loans with flat monthly payments. (Amortize means to gradually reduce or pay off a debt with regular payments, a.k.a. a mortgage.) The payment goes toward both your interest and principle.
However, over the course of the mortgage, the amount that goes toward the principal payment gradually increases. You pay more toward interest at first because the interest being charged is calculated based on the present outstanding balance of the mortgage. As that outstanding balance drops, more principal gets repaid. The smaller the mortgage principle, perhaps because of a large down payment, the less interest is charged. While your mortgage payments don’t decrease, the amount paid toward interest does. As that happens and you pay more of the principal, you build equity at an increasing rate each year.
Shorter Term Loans and Extra Payments
By taking a longer-term mortgage, you pay more principal over time with steady payments. However, sometimes you want to speed up the process, which can help build equity. One way to do this is take a shorter-term loan. Payments will be larger but interest rates will most likely be lower. It may sound daunting, but it means spending less on interest over time and paying back the principle (a.k.a. building equity) faster.
Extra payments are also another option. Even with a 30-year mortgage, if you can pay more than the required amount, your debt will go down and that means building equity. You just need to be sure your lender applies the payments to the principle and not the interest. Putting yourself on a 15-year payment plan with your 30-year mortgage is another way to do this. If necessary, you can always drop back to the 30-year payment amounts and not sweat it too much.
Another way to build equity feels a bit like magic: price appreciation. When your property (remember your home’s value is based on land and the structure) increases in value, the amount you owe becomes less. The best case scenario is that your property value increases without any remodeling, etc. The school wins an award or the government puts in mass transit or a new company arrives and your area is the next hot spot for affordability. You’ve invested no money (capital) in the structure, but your property value went up.
Home improvements done over time also build equity. If you are specifically aiming to build equity with the improvements then pick projects with a high return on investment such as replacing a garage door (seriously) or adding a wooden deck.
Upkeep is another great way to build equity. It isn’t as exciting as the other two, but it is just as effective. Again, the value of your property is assessed based on the land as well as the structure. The land is the land in terms of location and size, but if you maintain the structure and mow the lawn, then you’re building equity slowly but surely and that’s not all bad.
The upshot of all of this is that it is very possible to build equity in your property with effort (and maybe a little magic of appreciation) and time. Doing so turns your home not just into a great place to live but a great long-term investment, too.