“Don’t throw away your rent money every month. Start building equity” they say. But, if you don’t understand equity at its core, these words likely flow in one ear and out the other. So, if you’re considering buying a home, or already own one, make sure you understand the foundation of homeownership—equity. Let’s get to it. 5 mins or less. No lectures. (And a really sweet analogy to make it simple.)
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Put simply, equity is the amount of home you own. It’s the difference between how much your home is worth and how much you owe, shown as a dollar amount. Simple, right? Before we dive into how you increase your equity, let’s use an analogy of a garden to keep it simple.
If your home is a garden, your down payment is a pack of seeds. When you buy a house and pay your down payment, you’re planting your seeds into a small patch of dirt. If you have a down payment of $20,000, these seeds are your first $20,000 in equity. The place to start.
For a little while, not a whole lot happens with your equity, much like seeds in a garden. You’re not going to be harvesting any fruits yet. In these early times, your monthly mortgage payments will primarily be going toward the cost of borrowing money, called interest. (This is normal, and the premise of almost any mortgage.) With each month’s payment, less and less of your payment will be going toward interest, and more will be going toward your mortgage balance, or principal. And that’s where sprouting begins.
While you’re paying down your mortgage balance, there are a few natural factors that also help your seeds (aka equity) grow. Sun and rain are akin to the natural increase in value of your home. Things like neighborhood value going up (called appreciation) and market conditions both impact your home’s value. Based on historical data, we can see that home values naturally rise over time. And when your value rises, you know what that means.
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So, you’ve got a bit of equity building. You’re making regular mortgage payments and maintaining your home, and your home’s value is also increasing with the market. The sprouts are now becoming plants. Equity plants full of fruit. This is the point where everyone who lectured you on owning a home is talking about. You now have sizeable equity (ripe fruit) and you can use it however you’d like. You can keep that money in your home for later use, or you can harvest it (aka take cash out) and use it to your advantage now.
To take your equity out, you can use a cash-out refinance or a home equity line of credit. The first gives you a lump sum of cash and the other gives you the ability to take out cash over an extended period of time. Either way, you can use that money—ahem, fruit—to do anything, including improve the value of your home with renovations. That’s using your equity to build even more. Boom.
To speed things up a bit, you can go beyond these baseline steps—fertilizer, if you will. Knowing the goal of building equity is to either reduce your mortgage balance, or increase the value of the property, there are a number of things you can do to speed up the process. Three key ways are (1) making home improvements or renovations, (2) making extra payments to your principal, and (3) refinancing to shorten your term and pay off your mortgage sooner.
If you decide to make home improvements to increase the value of your home, you’ll want to consider the best types of home improvements to maximize your dollars spent, also with the needs you require. As with any major decision, it’s best to consult with an expert, like a real estate agent, first.
You probably saw this one coming. If the first home you buy is your first equity-generating garden, it makes sense when buying a second home or investment property, you’re doubling up on equity creation. (Á la a new garden.)
Of course, you only want to do this when you’ve got your first investment (garden) under control and producing fruit. You can even use that fruit (equity) from your first garden to purchase your next one. Then, you’ve got two equity generating operations.
Check out this article if you want to know more about "expanding" to new a “garden.”