Home Equity: What it is and How to Make it Work for You
When you buy a home, it’s not just a place to settle down. It’s also an investment—one that you happen to live in. So while it’s important to figure out how many bedrooms you want and what square footage works for you, it’s just as important to understand the financial aspects of home ownership. A good place to start is home equity.
What is home equity?
Equity is the amount of your home’s value that you actually own. When you buy a home, you likely will take out a mortgage to pay for part of the initial purchase price. But over time, you will pay down that mortgage, thus increasing the portion of your home that you own outright. Your home may also increase in value, which also adds to your home equity. Note that if you take out an interest only mortgage, you won’t be paying down any principal, so won’t increase your home equity through loan payments.
A home equity example
Here’s an example. Let’s say you bought a house for $200,000 and had a 20% down payment, which is $40,000. That down payment is the amount of home equity you start with in this case. After 5 years, let’s assume you’ve paid off $25,000 of the principal on your mortgage. You’ll also be paying interest along the way, so your total mortgage payments will have added up to more than $25,000. Let’s also say that your home increased in value by $25,000 and would now be worth $225,000 if you sold it.
In this case, your equity would be the $40,000 that you started with, plus the $25,000 that you paid off, plus the $25,000 increase in value for a total of $90,000. If you sold your home, you would receive that $90,000, minus any transfer costs like taxes and paying for a real estate agent.
For many homeowners, their property is the most valuable asset that they have. There are many ways that you can take advantage of your home equity.
Why is home equity important?
Once you’ve built up home equity, there are lots of things that you can do with your investment. If you decide to sell your current home, you can use the money from your home equity as a down payment on your next home. That means that you may be able to start out with a higher percentage down payment on your new home than you did on your last home, depending on how much your new home costs.
You can also borrow against your equity with a home equity loan, also known as a second mortgage. Home equity loans have lower interest rates than credit cards and can be used for any purpose. However, you should always be careful with these loans because your house secures the loan. This means that if you don’t make your payments, the lender could foreclose on your home.
You can also take out money from your home equity with a cash out refinance. In this option, you get a new mortgage for a higher amount than your current mortgage. You’ll get the difference (minus closing costs) as cash. This is a good option if mortgage rates have gone down since you initially got a mortgage. Keep in mind that your home equity will go down in this situation and you’ll have to start paying back what you’ve taken out in mortgage payments.
Thinking about your future
Finally, you can look at home equity as part of your retirement savings if you think that your home will hold its value and you’ll be willing to downsize in retirement. You could sell your current home, buy a smaller home, and use the difference in price to add to your retirement funds.
Home equity can be a powerful investment. Understanding it is important as you think about buying because it is a tool that you can access throughout your life.