Homeownership comes with plenty of perks, But one important financial benefit is the opportunity to build home equity, which is considered a common way to generate wealth over time.
Read on to learn how homeowners can help build equity and increase the value of their home.
What Is Home Equity?
In order to understand how building home equity works, it’s important to understand exactly what it is.
Equity is the amount of your home you actually own. More specifically, it’s the difference between how much you owe your lender and how much your home is worth.
To calculate home equity, simply subtract the amount of the outstanding mortgage loan from the price paid for the home. So if a home is worth $350,000, and the homeowner owes $250,000 on their mortgage, they have $100,000 of equity built up in their house. Their mortgage lender still has an interest in the home to the tune of $250,000 and will continue to have an interest in the home until the mortgage is paid off.
7 Smart Ways to Build Your Home Equity
1. Making a Big Down Payment
Homeowners can get a jump on building home equity when they’re buying a home by making a large down payment.
Typically, homebuyers using a conventional loan will put down at least 20% as a down payment to avoid having to pay mortgage insurance. That means that right off the bat, the homeowner has a 20% interest in their home. They can increase this amount by putting even more down. A down payment of 30%, for instance, will increase equity and potentially give the homebuyer more favorable mortgage payments and terms.
If making a large down payment means having less in emergency savings, however, the home buyer may want to use other methods to build equity.
2. Prioritizing Mortgage Payments
Each mortgage payment a homeowner makes increases the amount of equity they have in their home. Making mortgage payments on time will avoid potential late fees.
Keep in mind that a portion of each mortgage payment goes toward interest and sometimes escrow. You’ll want to take these amounts into account when calculating how much equity is accruing.
3. Making Extra Payments
Extra payments chip away at a loan’s principal, help build equity faster, and potentially save thousands of dollars in interest payments. Even if it’s only a little bit each month, paying more than your regular mortgage payment amount can help you increase how much home equity you build.
If adding some extra cash each month isn’t feasible, perhaps making one-time payments whenever possible — when you get a bonus at work, for instance — would be an option.
To ensure those payments are applied correctly, be sure to notify the lender that any extra or lump-sum payments should be put toward the loan’s principal.
Beware that some lenders may charge a prepayment penalty to borrowers who make significantly large payments or completely pay off their mortgage before the end of the term. Before making extra payments, consider asking the lender about a prepayment clause.
4. Refinancing to a Shorter Term
You may also consider refinancing with a loan that offers a shorter term. For example, a homeowner could refinance their 30-year mortgage to a 20-year mortgage, shaving off up to a decade of mortgage payments. However, doing so means they will also be increasing the amount they pay each month.
Still, shorter-terms loans may have the added benefit of lower interest rates, which could soften the blow of higher monthly payments.
Mortgage refinancing is not necessarily a simple process, nor is it guaranteed that a lender will offer a new loan. Homeowners can increase their chances of securing a refinanced mortgage by maintaining healthy credit and a low debt-to-income ratio. It may also help to have equity built up in the home already.
5. Renovating Your Home
Making home improvements typically increases the value of a home, which will likely increase equity. Renovating a home’s interior can be a good place to start.
Minor renovations like updating light fixtures and repainting can add some value to a home. Larger projects such as updating the kitchen, adding bathrooms or finishing the basement may yield good returns on the investment.
Weighing present cost against potential future gain may be a good thing to do before tackling a big project. The idea is that making these improvements now, and then being able to sell at a premium will mean recouping your expenses and then some. An online home improvement project calculator can help you estimate the cost of projects and how much value they could potentially add.
6. Sprucing Up the Outside
Similarly, adding to a home’s curb appeal may also increase its value. A fresh coat of paint, a well-maintained lawn, and tasteful landscaping could help increase a home’s desirability and the amount that buyers are willing to pay.
Mature trees, for example, can potentially add thousands of dollars to a home’s resale value. If you’re thinking of selling in a decade or more, planting a tree now could have a big effect on sale price later.
Increasing usable outdoor space by adding a deck or patio and installing good outdoor lighting may increase the value of your home.
7. Waiting for Home Values to Rise
The real estate market is always evolving, and sometimes, playing the waiting game could help you build equity. For instance, if your neighborhood becomes more popular, home prices could start to rise. If that happens, it may be worth keeping a home there longer to take advantage of the trend. Of course, the flip side is that housing prices may drop over time, which could mean a loss in equity.
Why Build Home Equity?
Building home equity is important because it gives the homeowner the opportunity to convert that equity into cash when the need arises. This is commonly done when a home is sold. But the equity in a home can also be important when taking out a home equity loan, which could allow the homeowner to use the value of their home while still living there.
For a home equity loan, a lender provides a lump-sum payment to the borrower. The amount must be repaid over a fixed time period with a set interest rate. As with a personal loan, home equity loans can be used for a variety of purposes. The loan is backed by the value of the home and typically must be repaid in full if the home is sold.
A home equity line of credit, or HELOC, is a revolving line of credit that uses the value of the home as collateral. Unlike lump-sum loans, a HELOC allows the homeowner to borrow money as needed up to an approved credit limit. That amount is paid back and can be drawn on again throughout the course of the loan’s draw period. While a person’s home is likely to be their most valuable asset, it’s also valuable purely because of its provision of shelter.
Researching and understanding all of the risks involved with loans that use a home as collateral, including that it could be lost if the loan is not paid back, is important before considering this option.
The Takeaway
There are many ways to build equity in a home. Different strategies include making a large down payment or extra monthly mortgage payments, refinancing to a shorter term, renovating your home, or waiting for home values in your area to rise. Whatever your strategy, home equity can provide you with a valuable resource that can be used when a financial need arises. Often this resource is tapped into by means of a loan that is secured by the home. However, this means if the loan is not repaid, a homeowner could lose their home.
If you want to avoid using a home as collateral for a loan, consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. And checking your rate takes just a minute.
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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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