Just as a road trip is more than simply reaching your destination, homeownership has many benefits beyond simply providing you with a roof over your head. One of those benefits is the opportunity to build home equity—but what exactly is equity and how can you build it?
In the simplest terms, equity is the difference between how much your home is worth and how much you owe on your mortgage.
Take a look at this example:
Let's say you bought a $250,000 house with a down payment of 7% (approximately $17,500). That would result in a loan amount of $232,500. You secured a 30-year fixed-rate mortgage at 4.5%, resulting in a monthly mortgage payment of $1,178 without taxes and insurance.
To calculate your home equity, subtract the amount of the outstanding mortgage loan from the price paid for the property.
At the time you buy, your home equity would be $17,500 or the amount of your down payment. For perspective, once you have paid off your mortgage you have 100% equity in the home.
So, how do you build equity?
You build equity in two ways: by paying down your mortgage over time and through your home's appreciation.
Each month, you will make monthly mortgage payments that will decrease the amount you owe on your loan.
Continuing with our previous example, let's look how your equity would increase after ten years of mortgage payments. After ten years, your unpaid principal balance is down to $186,208.
Using the formula from above, your total equity is now $63,792. Note, this is your total equity only if the value of the property remains the same as it was ten years ago – which is where appreciation factors in.
Over the course of your mortgage, it is unlikely the value of your property will remain the same as when you originally purchased it. The national average for home appreciation is 3% per year. If you live in a neighborhood where property values are going up overall, consider the possibility that your home equity may increase as well.
In our example, if your home appreciated by 3% annually, your home's value would increase from $250,000 to $335,979 after ten years. That's a 34% increase in value.
Using the formula (home value) – (principal owed) = (home equity) you would have $149,771 in equity.
It's important to note that some markets appreciate faster than others. It's also possible for home values to depreciate due to economic conditions, lack of upkeep, or a drop in neighborhood home values.
Building equity is a critical part of homeownership and can help build financial stability over time. To learn more about homeownership, be sure to follow our spring homebuying series.