Owning a home is a financial milestone, and often one of the most important, and expensive, purchases of a person's life. After the final papers are signed, and the welcome mat is spread on the front porch, something important starts to build: home equity. Understanding home equity is key for financially savvy homeowners.
So, What Is Home Equity?
Home equity is an important asset for any homeowner: it's the share of your home that you own. For example, if your house is worth $300,000, and you have a $200,000 mortgage, you have $100,000 in home equity ($300,000 value - $200,000 owed on your home = $100,000 home equity). Banks will allow you to take out a loan, or a line of credit, on your home equity. While credit cards and most other lines of credit are unsecured, home equity loans or lines of credit are secured by your home. This means that banks will likely give you more favorable interest rates, but if you fail to repay your loan, you could lose your home.
Home equity was a key concept in the housing market collapse in 2008. Housing prices fell 41% between June 2006 and December 2011. Houses that were previously appraised at $300,000 were selling for less than $200,000. As housing prices plummeted, home equity was lost in the blink of an eye. Those who had used their home equity for loans or lines of credit before the crash lived to regret it. Though their home equity was in some cases completely eliminated by the falling market, homeowners were still on the hook for home equity loans spent, with their houses on the line as collateral.
But according to financial experts, home equity doesn't have to be so dangerous. As the housing market continues to recover from the crash in the late 2000s, the market is seeing home prices rise and home equity increase. The New York Times reported that in the third quarter of 2015, homeowners have seen the highest return on their home investment since 2007: they earned an average of 17% off of their purchase price. As home equity increases, homeowners may feel more comfortable using some of their home equity as a low-interest, tax-deductible financial tool.
How Can I Build Home Equity?
The more home equity you build, the better: this sum is added to your net worth and can be used in a variety of ways. Here is how to build home equity.
- Start with a sizable down payment. Depending on the value of your down payment, your first months (or even years) of mortgage payments will simply go toward paying off the interest on your loan, without building home equity. By paying upfront with an initial down payment, you can ensure that you start to build home equity right away.
- Make regular mortgage payments. Each time you pay your mortgage, you are investing more in your home by building home equity. Don't miss payments or pay late, which may result in late fees that could have gone toward building the equity in your home. You can do even better by adjusting your budget to pay a little extra toward your mortgage each month. This extra payment will often go straight toward the principal (or the amount borrowed), not the interest of your loan. As you pay off your interest and principal, you build more home equity.
- Watch the housing market. Ideally, as the housing market rises each year, so will the value of your home. As your home's value increases, you will build home equity without even trying. Though the housing market has been unpredictable in the last decade, it is starting to stabilize. Even if you do end up losing equity in your home due to the housing market, you can wait to use home equity until the market becomes more favorable.
- Invest in home improvements. Home improvement projects can do more than just increase your quality of life. They can add significant value to your home, which raises home equity. Focus on high-impact improvements that are popular in your market. Before investing in any major home improvements, do your research to compare the cost of the remodel to the value added to the home. Hardwood floors, updated bathrooms, and even minor repairs and neutral paint jobs can significantly add value to your home, increasing your home equity.
How Can I Use Home Equity?
If you have good credit and home equity, you may be able to take out a loan or line of credit secured against your home. Home equity loans can be more advantageous than other loans, because they typically have lower interest rates, and the interest on the loans can be tax-deductible. First, carefully consider your reasons for taking out this loan. Putting your family home at risk for restaurant tabs, luxurious vacations, or designer duds is probably unwise. However, home equity is a valuable asset that can be used after appropriate consideration. As with any loan, make sure you have a solid understanding of the risks, repayment agreements, and terms of the loan.
- Home Equity Loan A Home Equity Loan is an advance on your home equity, and will provide you with a large lump sum of money at one time. Typically, repayments are set over a fixed period with a fixed interest rate. The unchanging monthly payments can provide more ease in monthly budgeting.
- Home Equity Line of Credit Another option is to open up a line of credit using your home equity. This is a more flexible option, as you can withdrawal money as needed, instead of a large, one-time sum. Your payments will vary as your balance increases and interest rates change.
Consult your financial advisor before taking out a loan of any kind, and realize that banks and lenders love home equity loans. Homeowners often prioritize the payments out of fear of losing their primary residence. So, financial experts recommend that these loans should be used in special circumstances, with considerable deliberation. It may be wise to use home equity to finance a child's education, to consolidate debt, or to significantly add to the value of your home.