Definition of Home Equity: Home equity refers to the portion of a home's value that you truly own. It is the difference between the market value of the property and the outstanding balance on any mortgage or loans secured by the property.
How Home Equity Builds: When you buy a home with a mortgage, you make regular payments to the lender over time. These payments consist of both principal (the amount you borrowed) and interest (the cost of borrowing the money). As you continue making mortgage payments, the amount of the principal decreases, and your home equity increases.
Additionally, if the property's value appreciates over time due to market conditions or home improvements you make, your home equity can also increase. Conversely, if the property's value declines, your home equity may decrease.
Example of Home Equity: Let's say you purchased a home for $300,000 with a 20% down payment ($60,000) and obtained a mortgage for the remaining $240,000. Initially, your home equity would be 20% of the home's value, which is the amount you put down as a down payment.
Over the years, as you make mortgage payments, the outstanding balance decreases, and if the property's value appreciates, your home equity grows. For instance, if you have paid off $50,000 of the mortgage principal and the property's value has increased to $350,000, your home equity would be $110,000 ($350,000 - $240,000).
Significance of Home Equity: Home equity is a valuable asset and an essential part of your net worth. It can serve several purposes:
Building Wealth: Home equity represents an ownership stake in a tangible asset that often appreciates over time. It can be a significant contributor to building wealth and financial security.
Borrowing Power: Homeowners with substantial equity may have the option to use that equity as collateral for loans or lines of credit, allowing them to access funds for various purposes, such as home improvements, education expenses, or debt consolidation.
Selling or Refinancing: When you decide to sell your home, your equity is the amount you'll receive after paying off the remaining mortgage and any selling costs. Alternatively, you can choose to refinance your mortgage to access lower interest rates or cash out a portion of your home equity for other uses.
Retirement Planning: For many people, their home's equity becomes a vital component of their retirement planning. It can be used to downsize to a smaller home, supplement retirement income, or fund other retirement-related expenses.
While homeowners typically enjoy the benefits of building home equity, renters don't have this opportunity. As a renter, you don't build equity in the property you live in.