Most people who buy a home don't purchase the property outright. Rather, they come up with a down payment that represents a portion of their home's price and finance the rest with a mortgage. The amount of your property that you actually own is known as home equity. The more you have, the better.
How is home equity calculated?
Home equity is determined by taking the market value of your home and subtracting the amount left on your mortgage. If your home is worth $400,000, but you owe your mortgage lender $300,000, you have $100,000 -- or 25% -- equity in that property.
When you first buy a home, the convention is to put down at least 20% of its purchase price. The more money you put down up front, the more instant equity you get. Once you pay off your mortgage in full, you'll have 100% equity in your home.
Why is home equity important?
Having equity in your home can help in a number of ways. First, if you build equity and then sell your home at a profit, you can take your proceeds and use them to invest or to purchase another home.
You can also borrow against your home equity by either taking out a home equity loan or getting a home equity line of credit. With the former, you get an actual loan. The collateral is the equity you've built in your property. You can use that money for home improvements or for a purpose unrelated to your home.
With the latter, you're not getting an actual loan. You're getting the option to borrow against your home up to a certain limit as the need arises. You'll only pay interest on a home equity line of credit when you borrow funds. You need a certain amount of equity in your home (usually 15–20%) to qualify for these borrowing options, which is why it pays to build equity.
How to build home equity
There are several steps you can take to increase the equity you have in your home.
For one thing, start by making a larger down payment. Most buyers are advised to put down 20% to avoid private mortgage insurance, but the more money you put into your home up front, the more instant equity you get. But you should also be wary of tying up too much cash in a home, especially if you've snagged a low interest rate on your mortgage.
Another good way to build home equity is to pay off your mortgage ahead of schedule. Doing so will also limit the amount of interest you pay over the life of your home loan. Keep in mind that you'll build equity by simply keeping up with your existing mortgage payments, too. As you make those payments over time, more and more money will go toward your loan's principal so that, eventually, your equity rises.
Finally, you can increase your home equity by making smart improvements that raise the value of your property. Remember, home equity is your home's value minus your outstanding mortgage amount. Let's imagine your home is worth $400,000 and you owe your mortgage lender $300,000. If you make improvements that raise your home’s value to $450,000, you'll have an extra $50,000 in equity, assuming the same mortgage balance applies.
Often, your home's value will rise on its own over time. It doesn’t matter why your home’s value has increased -- the more the property is worth, the more equity you have.
Home equity is a good thing to have, but it may take a while to build. Be patient -- once you have a nice amount of equity in your property, you’ll have more options at your disposal.