Home equity is the difference between the value of your home and the current outstanding mortgage debt. Most lenders require that you have a down payment of 10 percent to 20 percent of the home purchase price. At the time of purchase, that is the value of your home equity.
The amount of your home equity, however, changes over time as you make mortgage payments and the value of your home changes.
How Can You Build Home Equity?
Own Your Home
You can typically build equity in your home by simply owning it. Under normal market conditions, home values appreciate every year. As the value of your home increases, so does the value of your home equity.
Consider an example where you owe $200,000 on your $250,000 home. Imagine that tomorrow your home increases in value to $260,000. The value of your home equity increased from $50,000 to $60,000.
Make Mortgage Payments
Another way to build home equity is by making payments toward your mortgage. Unless you have an interest-only mortgage, every monthly mortgage payment that you make gets split between paying the interest that is due and paying down your principal balance.
The portion of the payment that goes to pay down the principal is smallest in the first month and gets a little bigger every month. So, each time you make a mortgage payment, you reduce your outstanding debt and increase your home equity.
You can also make additional payments toward your mortgage in order to build equity faster. When you pay more than the monthly payment due on your mortgage, all of the additional money goes to pay down your principal balance.
Since you reduce the outstanding balance a little more, the interest due the next month will be smaller. As a result, the portion of your next payment that goes to pay down principal will also be slightly larger. Every time you pay a little extra on your mortgage, you can increase the rate at which you build equity in your home.
Why Is Building Equity in Your Home Important?
It’s important to build equity in your home because it can give you financial flexibility and access to home equity products. Homeowners have the opportunity to access the equity they have built in their home by taking out a home equity loan or home equity line of credit.
Both of these debt products allow homeowners to gain access to the equity they have built in their homes in order to have the cash to pay offor consolidate credit card debt, go on vacation, pay college tuition, or renovate their home.
Home equity gives homeowners an additional source of cash and the financial flexibility they need. The amount homeowners can borrow, however, is dependent upon the amount of home equity they currently have. You can learn more about the pros and cons of home equity lines of credit here.
And for many Americans, their home is the single largest asset they own. Building equity in your home is a way to build the value of your assets, reduce the value of your debts, and increase your net worth. Your home is a unique type of asset because it not only gives you shelter but also creates wealth and financial security.
How Could You Lose Equity in Your Home?
Unfortunately, home values do not always increase. At the local level, neighborhoods can fall into disrepair and become less desirable over time. Under these conditions, property values can fall rather than appreciate every year. At the national level, there are macroeconomic forces that can decrease home values.
This is precisely what happened during the housing crisis in 2008. Home prices dropped precipitously, and the results were especially bad in markets like California and South Florida, which had experienced a fast run-up in prices. In locations such as these, homeowners not only saw their home equity decrease but often ended up with a negative amount of equity in their homes.
This is called being underwater in your mortgage. Again, consider the example where you have a $250,000 home and owe $200,000 on the mortgage. If the value of your home fell to $195,000, you would now have negative home equity. Following the housing crisis, many Americans who experienced negative home equity were unable to sell their homes and ended up losing their homes through foreclosure.
However, having a larger amount of home equity can provide homeowners with some protection against falling home prices.