What Is Equity and Why Is It Important?
Have you heard that owning a home helps ‘build equity’ but still not sure what that means?
Posted: June 26, 2017 by Natalie Arnold
You’ve probably heard people throw around the word “equity” when they’re talking about homeownership. You might have heard someone say that owning a home helps you “build equity” or perhaps you heard someone talk about “borrowing against equity.”
But what exactly is equity? And why does it matter?
What Is Equity?
Equity is what you own, minus what you owe. It’s the percentage of your home value that belongs to you free and clear.
If your home is worth $250,000 and your outstanding mortgage balance is $200,000, then you have $50,000 of equity in your home.
How Does Equity Grow?
There are three common ways in which your home’s equity can grow: market appreciation, forced appreciation, and debt reduction.
Market appreciation takes place when the value of your home rises due to factors caused by the overall local, state or national economy. If your home is located in a neighborhood that is experiencing a sudden burst of new jobs and population growth – and if that population growth is outpacing new housing starts – then there’s a likelihood that the value of your home may rise due to market appreciation.
Let’s return to the previous example. Your home is worth $250,000 and your mortgage balance is $200,000, meaning that you hold $50,000 in equity. Let’s assume that home values in your area start climbing steeply. Your home is now worth $300,000. Guess how much equity you hold? You now have $100,000 in equity. As the homeowner, you benefit from all market gains.
Forced appreciation is another common way that homeowners build equity. While market appreciation is based on factors outside of your individual control, forced appreciation is the direct result of your actions.
When you hear about people making upgrades for the sake of boosting resale value, they’re referring to forced appreciation. Imagine that you carefully plan and execute a kitchen remodel. You replace the 30-year-old cabinets with a new set; you replace the laminate countertops with builder-grade-granite; you replace the linoleum flooring with hardwood, bamboo or tile.
Assuming that you managed this remodel in a cost-efficient manner and made upgrade choices that are consistent with your neighborhood, the value of your home may exceed the cost of the renovation.
For example, if you spend $8,000 on the renovation, which results in a home that’s now worth $15,000 more, this means you increased your equity through forced appreciation.
Finally, you can boost equity through debt reduction, which means that you reduce the principal balance of your mortgage. Mortgages are amortized, meaning that a larger percentage of your payments apply to interest at the beginning of the term, while more of your payments apply to principal near the end. If you want to accelerate equity growth at the start of your term, you can make extra principal payments. This boosts your equity while also lowering the total interest you’ll pay over the life of the loan.
A combination of these factors can accelerate your equity growth. Since equity is the difference between “what you own” and “what you owe,” the 1-2 combination of boosting home value while also reducing the mortgage balance can be an effective way to rapidly build equity.
Why Does Equity Matter?
There are many advantages of holding equity.
First and foremost, equity boosts your net worth. The higher your equity, the higher your overall net worth. Your net worth can give you feedback on your overall financial health, and can help you make crucial financial planning decisions.
Secondly, you can borrow against your equity and, if you choose, invest this money. Some homeowners borrow against their equity to start businesses; others borrow to remodel their homes or to purchase investment properties.
The home equity loan, home equity line of credit, and cash-out refinancing are several options that homeowners can choose from if they want to borrow against their equity.
Finally, homeowners who decide to move can use the equity from the sale of their home to make a down payment on another home. This allows homeowners to “trade up” without needing to save cash for a down payment.
Furthermore, homeowners who downsize (meaning sell their current home and move into a smaller and less-expensive home) may cash out their equity – using some of their equity to purchase their less-expensive home and receiving the rest as cash.
What Should I Do?
Equity can be a form of ‘forced savings.’ Once this equity is locked into your home, you’ll have the advantages and opportunities that come from holding a high-equity position, without the same temptation to spend this money that you might have if it were liquid cash.
Assuming that you’re not planning any major projects that require a large cash outlay – such as starting a business, buying an investment property, launching a renovation or paying for college – you may want to focus on boosting your equity by accelerating your mortgage payoff, making strategic value-boosting upgrades, or both.