Buying a home is the biggest investment that many people will make. And building equity is one of the main reasons people put so much time, effort and money into the process.
The amount of home equity built can be subject to factors that can’t be controlled, like the waxing or waning popularity of a neighborhood. But there are also concrete steps a homeowner can take.
What Is Equity in a Home?
In order to understand how building equity works, it’s important to understand exactly what it is.
Equity is the value of a homeowner’s interest in their own home. In other words, it’s the value of the portion of the home that actually belongs to them. This portion is calculated by subtracting a home’s mortgage and any other liens on the house from its fair market value.
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.
Many strategies for building equity take advantage of this relationship by lowering the interest paid on a mortgage loan.
Recommended: How to Calculate Home Equity
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 more down. A down payment of 30% 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
With each mortgage payment a homeowner makes, they are adding to the pool of money that began with their down payment, increasing the amount of equity they have in their home. Making mortgage payments on time will avoid potential late fees.
A portion of each mortgage payment goes toward interest and sometimes escrow, amounts to take into account when calculating how much equity is accruing.
3. Making Extra Payments
Increasing the amount of home equity built with each mortgage payment may be able to be done by paying more than the regular payment amount—even if it’s only a little bit each month.
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.
Notifying the lender that any extra or lump-sum payments should be put toward the loan’s principal is necessary to make sure those payments are applied correctly.
Extra payments chip away at a loan’s principal, help build equity faster and potentially save thousands of dollars in interest payments.
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, asking the lender about a prepayment clause is a good idea.
Recommended: Prepayment Penalties: Why They Exist and How to Avoid Them
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. Beware that by doing so they will also be increasing the amount they pay each month.
However, shorter-terms loans may have the added benefit of lower interest rates, which may soften the blow of higher monthly payments.
Refinancing a mortgage 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.
Would a small home in a neighborhood of modestly priced houses be able to recoup the cost of adding commercial appliances and marble countertops to the kitchen? Or would a better option be updating with less expensive materials?
Recommended: Home Improvement Project Calculator
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 can increase a home’s desirability and the amount that buyers are willing to pay.
Mature trees 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
Sitting back and doing nothing actually has the potential to see an increase in a home’s equity. Over time, the value of a home may increase, as the neighborhood becomes more popular, for example.
If home prices in an area are on the rise, it may be worth keeping a home there longer to take advantage of the trend. Of course, the flip side is 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 tapped into through the use of a home equity loan, which might allow the homeowner to tap 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.
And 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, providing a resource that can be tapped when a financial need arises. Often this resource is tapped into by means of a loan secured by the home, though, which can present a risk of losing the home if the loan is not repaid.
To avoid using a home as collateral for a loan, a personal loan might be an option.
An unsecured personal loan from SoFi can be used to finance things like home renovations, medical procedures, consolidation of credit card debt, and moving expenses, among other things.
SoFi Home Improvement Loans have no fees required and offer low rates to qualifying applicants.
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SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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