Understanding Home Equity
If you own a home, it’s important to understand what home equity is, how to accumulate it, what it can do, and how to use it. Whether you want a nest egg for a rainy day or you’re planning to make your equity work for you, the first step is knowledge. So, let’s get started!
What Is Home Equity?
When you buy a home, you take out a loan called a mortgage that you pay down monthly, with interest. Even though you are the official owner of the home, you don’t technically own the portion of it that you haven’t paid for. As you pay off the mortgage, you begin paying down that loan and gain a larger portion of ownership with every payment.
Equity is therefore the part of your home that you own which increases as your loan reduces and your home’s value increases.
Home equity is the difference between what you owe on your home and what your home is worth. You can use this money even if you still owe money on your mortgage. The calculation is actually very simple: all you must do is subtract the amount that you still owe on your mortgage from the total value of your home.
It will look something like this:
Let’s say you paid $200,000 for your home. Over the years, you’ve paid off $26,000. Now you owe $172,000 on your home. Your home’s value has appreciated (gone up) and now it’s worth $222,000. Your calculation will be as follows:
$222,000 – $172,000 = $50,000
This means that if you sell your home, or borrow against your equity amount, you’ll have $50,000 cash in hand.
How Long Does It Take to Accumulate Equity?
Unfortunately, there’s no one-size-fits-all answer. Your initial down payment, monthly payments, interest rate, and repayment terms all affect how your equity accumulates.
Then there’s also the housing market to consider, which fluctuates over the years. Generally, it will take several years for you to build up any usable equity in your home. It can also take up to ten years for your home’s value to increase dramatically, depending on your location and the property cycle.
If you want to build equity faster, there are a few things you can do:
Put down a bigger deposit on your home when you purchase so you have to borrow less
Avoid an interest-only loan since this drags out your equity savings by postponing paying your
principal amount
Opt for a shorter mortgage period – 15 or 20 years is better than 25 or 30 years
Purchase a home in an up-and-coming neighbourhood to boost your home’s value faster (i.e.
near schools, shopping locations, and popular areas of your hometown)
Make larger monthly payments or choose accelerated payments to reduce your principal faster
How Can Home Equity be Used?
Home equity can be used in all sorts of ways. There are a few different avenues of putting your equity to work, a few options for how your equity pays out, and near-limitless things you can do with it once you’ve got it.
How To Get Home Equity in Cash
There are a few popular options for realizing equity in your home.
Firstly, you can sell your home. When the sale goes through, your lender will be paid out first. Then, you’ll receive the rest in a lump sum. Depending on how much of your loan you’ve paid off, and how much your home has increased in value, the equity you receive could be tens or hundreds of thousands of dollars. This is the most popular method of realizing large amounts of equity.
Alternatively, you can take out a loan, or borrow against your equity. Essentially, you receive the cash value of your equity, and that value is added back on to your debt amount. This method is popular for those who are strapped for cash because you can choose to borrow any amount from your home equity, be it $5000 or $30,000.
This is a riskier approach when you’re paying off debt and expenses because you run the risk of losing your home if you fall behind on your mortgage payments.
Another option is cash-out refinance. With this method, you refinance your home for more than what you owe on your mortgage. The extra money from the refinancing is then paid out to you to be spent however you wish.
Types of Home Equity Loans
There are two options when receiving cash from your home equity:
First, you can get a lump-sum loan and receive all your cash up front. With this type of loan, you’ll repay it in monthly instalments for a set period of years – usually between 5 and 15. For investing or consolidating debts, this is a good approach.
The other option is a HELOC, or home equity line of credit. A line of credit works similarly to a credit card: you have a large sum of cash available to you, but you only pay interest on what you use. Lines of credit are revolving amounts, so you could use $25,000 out of your $30,000 line of credit, pay off $5000, then take out $10,000. A line of credit is useful for long-term expenditures such as home renovations or tuition repayment.
What Can I Do with Home Equity?
Now that you’ve got your home equity, what can you use it for?
When used properly, home equity can be a strategic way to build your wealth. Many Aussies choose to use their equity for long-term investment. This can mean using it for a down payment on another property that you use for income, investing in yourself through a start-up business, or investing in the stock market.
Equity can also be used for more upfront purposes, such as consolidating debt, buying a new car, or paying off student loans. You could even use the equity in your current home to purchase a new home. You can use it to go on vacation, buy something you’ve always wanted, renovate your home, buy your child their first car, start a business, invest, pay off debts or expenses… the options are endless!