There are many reasons to pursue homeownership, from obtaining a yard for your dog to painting the bathroom whatever darn color you want. But one of the biggest financial reasons to own your own home is to start building home equity.
Home equity is considered one of the most common and accessible ways to build wealth over time, thanks in large part to the appreciation of real estate over time.
You can even leverage your home equity to take out loans and fund your retirement. But what, exactly, is home equity, and how does it work?
What Is Home Equity?
Home equity is the amount of your home value that you actually own. It’s calculated by subtracting your mortgage balance from the market value of your property.
For example, if your home is worth $350,000, and you’ve paid enough toward your down payment and home loan that your mortgage balance is $250,000, you own $100,000 in home equity. (Keep in mind that the $350,000 value might not be what you initially purchase your home for — that figure tends to, though doesn’t always, increase over time, which is part of how equity is built!)
Once you own home equity, you can borrow against it or make a profit if you choose to eventually sell the home.
In short, home equity is pretty great to have. But how is it built?
Building Home Equity
Home equity is primarily built in two ways: paying down your mortgage and seeing the value of your home appreciate over time. Both of these can be nudged a bit to help you build equity faster. Here’s how.
Putting Down a Larger Down Payment
Many buyers, especially first-time homebuyers, take advantage of programs that allow small down payments — sometimes as little as 3% of the home purchase price.
But when it comes to building equity, a higher down payment could help. The more you put down when you’re first purchasing your house, the more equity you have right out of the gate — and if you put down more than 20%, you’ll be able to skip the additional cost of private mortgage insurance, commonly called PMI.
When calculating mortgages, you’ll also see that the higher the down payment you can afford, the lower your monthly mortgage bill.
That said, substantial down payments can be prohibitive for many buyers, and it may make more sense to get in with a lower down payment and start building equity rather than waiting a long time to save up tens of thousands of dollars.
Paying Off Your Mortgage
If making a larger down payment isn’t possible, you might also be able to speed up your equity earnings — and save money on interest over time — by paying off a mortgage early.
Of course, you’ll need to consult your mortgage documentation to ensure that your lender doesn’t charge a prepayment penalty, or if it does, that it would still be a cost-efficient decision to make.
Only some lenders charge a prepayment penalty, and of those that do, only within the first few years (usually three to five).
Paying More Than the Minimum on Your Mortgage
If you can’t afford to pay off your mortgage early in its entirety all at once, you can chip away at the loan over time by making more than the minimum monthly payment.
It’s a good idea to ensure that the additional funding is going directly toward your principal balance (the amount of money you borrowed in the first place). That way, you’re dialing down the amount of interest you’ll pay before it can even accrue.
Staying in Your Home for Five or More Years
Along with chipping away at the amount you owe, the other function that increases equity is allowing your home to appreciate. Although that rise in value isn’t guaranteed, if it’s going to happen, it takes time.
Thus, staying in your home for a longer amount of time (at least five years) gives you a better chance at building enough equity for all the other costs of homeownership to be worth it.
Renovating
Allowing your home to naturally increase in value over time is one thing, but you can also take matters into your own hands and help drive up the value by renovating or remodeling. (Not sure aboutrenovations vs. remodels? Essentially, remodels are more extensive — and expensive.)
While even lower-cost renovations, like painting, can increase the home value a little, major repairs may have major costs associated with them. Sometimes, though, the equity increase you’d gain makes it worth going to the expense in the short term; home improvement loans can help make these efforts more accessible (but again, always look ahead to ensure that debt won’t eclipse the equity you’d stand to build).
Turn your home equity into cash with a HELOC from SoFi.
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Using Home Equity
So once you’ve built home equity, how can you use it?
For one thing, it adds to your overall net worth: The amount of equity you own in your home is value in your name, even if it’s not in cash. But you can also leverage your home equity in a variety of ways to glean actual spending power. Here’s how.
Home Equity for Your Retirement
Many people end up using home equity loans to fund their retirement, as certain types of these loans, such as reverse mortgages, don’t require repayment until the borrower moves out or dies.
That said, it’s important to think through the pros and cons of reverse mortgages, as borrowing against your home equity comes with risk. (For example, if the loan total ends up being more than the value of the home, heirs might lose the house, or need to refinance, if they can’t pay off the reverse mortgage in full.)
Home Equity to Purchase a New Home
Even if you end up moving, your home equity value can be borrowed against to help purchase a new home. In fact, some people end up taking out home equity loans to purchase a second or investment home.
Borrowing Against Home Equity
Along with the above-mentioned ways to use home equity, there are many other equity home loan types that can be used to liquify the cash wrapped up in your home and make it spendable.
Just be aware that these loans come with costs and risks. For example, if the housing market suddenly shifts and your home’s value decreases substantially, you may find yourself in a hole. In fact, if you can’t make the payments, you could even lose your home. Your home, after all, is the collateral for these loans.
Here are a few of the most common ways to borrow against your home equity:
• A home equity loan offers a borrower a lump sum of cash up front in return for fixed payments on a regular basis throughout the life of the loan.
• A home equity line of credit (HELOC), on the other hand, works kind of like a credit card: Those who take out HELOCs have the opportunity to tap into their equity and convert it to spendable cash as needed, up to a certain limit. Neither interest rates nor payments are usually fixed. Closing costs may be lower than those for a home equity loan, and sometimes waived entirely if you keep the credit line open for a number of years.
💡 For more info on HELOCs, check out our Guide to Home Equity Lines of Credit.
• With a cash-out refinance, a borrower takes out an entirely new mortgage while borrowing a portion of their existing home equity in cash. Closing costs are involved. (Here are details for those deciding between cash refinance vs. HELOC.)
Calculating Home Equity
Phew! That’s a lot of information. To recap, here’s how to calculate your home equity:
Total home value – total mortgage balance left = home equity
Keep in mind, again, that “home value” isn’t the same as “purchase price.” To know for sure what your home value is in the current market, you’d need an up-to-date appraisal, but you can use estimates from Zillow or your favorite real estate agent.
The Takeaway
While nothing is a surefire ticket to wealth, building home equity is one of the most historically reliable ways to do so. And down the line, home equity can be leveraged for a variety of loans.
Still have questions? That’s understandable; homeownership is a complicated topic. To better understand mortgages, SoFi offers a help center for home loans.
If you decide that you’re ready to buy, take a look at mortgage loans with SoFi. You might find a competitive fixed-rate mortgage that’s just the right fit, with as little as 3% down for qualified first-time homebuyers.
Photo credit: iStock/PC Photography
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